Your Debt Service Ratio – Calculating And Understanding It In 5 Easy Steps

Input Your Gross Monthly IncomeYour gross monthly income (GMI) being the money you earn per month before taxes and deductions. The easiest way find this number is to look at your most recent pay stub and you should find a balance that is listed as your GMI. Make sure you do not use your net monthly income as this number represents the earnings you make after taxes and deductions.Calculate Total Monthly Debt PaymentsThis means adding up all the expenses per month that are paying off debt. This might include car loans, mortgages, minimum credit card payments, student loans, leases or any other kind of debt you might be paying off. The sum of all your debt payments should be representative of a the average amount debt you pay off in one month.Divide Total Monthly Debt Payments into Your Gross Monthly Income

This part is pretty straight forward, you take the sum of your total monthly debt payments and divide it into your GMI. For instance, if your total monthly debt payments equaled $600 and your GMI was $2000, the resulting number would be 0.3 or 30% ($600/$2000 = 0.3). This number as a percentage is your debt service ratio and although it varies from bank to bank, most banks will only finance you if your debt service ratio is less than 0.45 or 45%.So How Does This Relate To Figuring Out What Monthly Payments I Can Get Financed For?To figure out what monthly payment you could get financed for, you simply subtract your debt service ratio from 0.45 or 45%. In the previous example it would be 0.45 – 0.30 = 0.15 or 15%. You then multiply this number by your GMI. Continuing with the previous example: 0.15 x 2000 = 300. Voila, the resulting number is the amount of monthly payments most banks will be willing to finance you for. So in our case the banks would likely be willing to finance us for $300 per month.Why Is It Calculated This Way?Good question! The maximum debt service ratio limit for most banks is usually close to 45% and for our purpose you can think of this number as somewhat of an arbitrary number. However, the banks have carefully determined this number so they can calculate what an acceptable risk should be for them when lending money. So essentially the banks don’t want to lend anyone more than 45% of their GMI. If you had no debt payments and a high credit rating, they would hypothetically be willing to finance you for monthly payments totalling 45% of your GMI. Basically most banks do not think it a good risk for you to have any more than 45% of your GMI being paid towards debt. Thus they have to subtract your current percentage of debt you pay per month (relative to your GMI) from 45%. The resulting amount is the percentage of your GMI that most banks would think is acceptable for you to add onto your monthly payments towards debt. At this point, if you did start paying the maximum monthly payment the banks would finance you for, you would be paying 45% of your gross monthly income towards debt. You would likely not be able to secure more loans after this because you have reached the banks limit of 45% (of GMI being paid towards debt). In the end, it is all about the bank calculating what is an acceptable risk to take on a loan.

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