Your Maximum Debt Capacity and the Debt to Income Ratio

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Your Maximum Debt Capacity and the Debt to Income Ratio


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There is a maximum amount of your monthly income with which you should repay the debt you incurred. Naturally, this in turn, would be related to the maximum amount of debt you carry. Lenders and credit agencies call this the debt to income ratio.

This is easily calculated, if you include all the amounts that fall under the headings shown below:

Monthly Debt Servicing Costs Monthly Income
Mortgage (incl. Property Tax and Insurance) of Rent Payment Total Monthly net (after Tax and Deductions) Income - if you want to be conservative, you should exclude bonus payments!
Payments on Home Equity and other Property related Loans Monthly Income from activities that would be shown on a US Tax form 1099
Car Payments Other Income (exclude windfalls, lottery winnings etc) such as interest etc
Credit Card Payments (at the minimum times two the minimum Payment) Child Support and Alimony payments being paid to you.
Other Loan or Note Repayments, payment to judgements or liens    
Child Support and Alimony Payments (if any)    
Student Loan Repayments    

Total Monthly Debt Service Payments (A) Total Monthly Net Income (B)

Now, divide (A) into (B) and multiply the result by 100. That will give you the percentage of your monthly income you pay in debt servicing costs. It is also known as the
Monthly Debt Service to Income Ratio.

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You should be aware that the debt servicing payments should include any payment arrangements you have made, such as, for instance, payments to hospitals or dentists for past treatments. The higher the percentage of debt servicing payments, the greater a credit risk you become. Future and existing lenders, such as credit card companies will look closely at that relationship, when they review your credit worthiness.

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How Lenders view and interpret your Debt to Income Ratio


When you apply to a financial institution for a loan or a credit card, the credit or loan officer will look closely at your current income and your current debt. The Debt to Income Ratio will be a major factor in the recommendation of the credit officer about your ability to repay any proposed granting of credit.

0-35% This is a good ratio that will result in acceptable credit conditions and interest rates. Most credit analysts and credit officers will recognize your ability to manage your debt. You might even get lower interest rates if your ratio is below 25% of monthly income.
36 - 40% These are border line ratios. You may have to provide some plausible reason to a lender why your ratio is that high and they may want to see an improvement over a specified time. A ratio in that range could now (2012)also result in a reduction of your credit card limits during the next financial review of the lender.
41+ % Such a high ratio will have a profound effect on your FICO Credit Score. Many financial institutions will no longer consider your credit application and if they do, your interest rate will be considerably higher. Lenders may also ask for additional securities, before they extend credit.

Checking your ratio regularly will help you manage your finances better, which should result in a better credit score and lower interest rates.


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