What Is Debt-to-Income Ratio and Why Does It Matter?

In this edition of "Bank of Dad", we answer questions about debt-to-income ratios and the best way to allocate funds in your 401(k).

by Daniel Kurt
Geo Barnett for Fatherly

I recently started looking for a new home and the mortgage firm checked on my debt-to-income ratio and had some questions. Why is this so important and what counts as a good ratio? – Craig L, Philadelphia

Lenders have all sorts of ways to measure your ability to pay back home loans, and with good reason. They’re fronting you a big chunk of money, and the investors who eventually buy most of those mortgages want to know they’re making a smart decision.

The debt-to-income, or DTI, ratio looks at your total loan payments in relation to how much income you’re making. The more money you bring in, lenders believe, the greater your ability to take on debt and still make your monthly due dates.

To calculate your number, you’ll first want to add up all your loan payments for a given month. That includes your mortgage, as well as credit cards, student loans, and car loans. You’d then divide that number by your gross income — in other words, how much you make before they pull out taxes and other deductions. The result is your debt-to-income ratio.

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Companies like Fannie Mae, which buy home loans from lenders on the secondary market, essentially set the rules when it comes to DTI ratios. In 2017, the mortgage giant loosened up its standards a bit, lowering its threshold from 45 to 50 percent (though there are some exceptions that I won’t get into here).

But these things can change at any time. For example, after seeing a surge of high-DTI loans, Fannie Mae announced earlier this year that it was placing more restrictions on borrowers who carry more than 45 percent debt.

The bottom line is that the lower you can get your number, the better. If you apply for a loan with a DTI ratio under 35 percent, you’re putting yourself in the best possible shape to get approved for a loan with a competitive rate.

I’m 32. I have one kid and another on the way. I have some savings and a decent 401(k) through work. How risky should I be with that 401(k)? – Carlos P., New Haven, CT

It’s hard to think of many decisions that affect your long-term financial health more than asset allocation. You want a portfolio that’s going to maximize your potential returns without exposing you to unnecessary risk.

Since you didn’t bring up any crises that would force you to pull money out of your 401(k) anytime soon, let’s assume the assets in there are staying put until you reach a fairly typical retirement age. At 32, that’s a good three decades away.

Over that time, you can afford to lean more heavily on stocks than an older worker who’s about to leave the workforce and head to Boca Raton in a couple years. The market may have dips between then and now, but you’ll likely have plenty of time to ride them out.

Martin Lundgren, president of Northern Lights, a fee-only advisory based in Seattle, says he’d recommend a portfolio with 80 percent stocks (with a 60/40 split of U.S. and international holdings) for a typical investor your age. The remainder would go toward a diversified basket of bonds, which provide a counter-weight against the ups and downs of the stock market.

That advice is basically in line with the “110 minus your age” axiom that a lot of financial gurus lean on to determine the overall percentage of stocks you own. When you reach age 60, for instance, your stock allocation would shrink to 50 percent. There are exceptions when this rule of thumb might not work — an early retirement, for example — but it’s a handy way to think about your gradual shift toward “safer” securities as you get older.

It pays to be a little more aggressive at this point in your life, when you can take advantage of market growth over several decades. “Over longer time periods, the major risk is inflation,” says Lundgren. “You want assets that keep up or exceed price increases.”

To keep an age-appropriate mix of stocks and bonds, you may have to periodically rebalance your assets over time. If stock prices go up, you might find that they now comprise 90 percent of your nest egg, instead of 80. To keep things in check, you’d want to sell some of your shares and use the proceeds to buy more bonds.

For more hands-off investors, Lundgren likes the idea of target-date funds, which automatically reshuffle your assets according to your investment horizon – that could be your retirement, or in the case of 529 plans, your child’s entry into college.

The good news is that a lot of 401(k) plans now offer these no-hassle funds. Just make sure you look at the annual expense ratio before you go that route. If you find any that charge more than one percent a year, you might want to steer clear.