Understanding The Key Financial Ratios For A Personal Financial Statement
Financial Ratios: A Deeper Understanding
Financial Ratios are the backbone of the loan application process. They are the calculations which have been developed to gain a picture of where an individual stands financially and what terms of a loan that individual could satisfy. They are used to protect both the lender from having a loan default and the borrower from making a monetary commitment they cannot meet. For more information on the simplistic breakdown of the common Financial Ratios please click Here. In this particular article, we shall be taking a closer look at the most common Financial Ratios and what the numbers computed imply both in loan acceptance and whether the terms of a loan are in the borrower’s best interest.
The Benchmarks of Debt-to-Income Ratio
Debt-to-Income Ratio, abbreviated as DTI, is one of the most basic and important of the Financial Ratios. It is a monthly comparison of what an individual makes versus what they owe each month. The DTI is essentially exactly what its name implies, what percent of an individual’s gross monthly income (the income before taxes have been taken out) is spent on bills each month. For a quick rundown of exactly what constitutes gross income and the debts used for this ratio click Here. To determine a DTI, first divide the Gross Income by the total monthly debts.
Monthly Debts / Gross Monthly Income x 100 = DTI
This should yield a number which is less than one. For example, if the Monthly Debts was $3,000 and the monthly Gross Income was $10,000 when divided the amount obtained would be 0.3. The 0.3 is then multiplied by 100 in order to convert it to a percentage, which in this case means that with these values of Monthly Debts and Gross Income the DTI would be 30%.
What is PITI?
It is also important to note that PITI must be figured into the monthly debt total. What is PITI? If an individual has a mortgage, the PITI stands for Principal, Interest, Taxes, and Insurance. These are the individual components which make up a mortgage payment. If you are considering taking on a new mortgage, these attributes can be used to determine what the monthly payment should be.
Why Monthly DTI Ratio?
The DTI and many of the other Financial Ratios use monthly values instead of yearly in their calculations. Breaking it down to monthly values is important because often the terms of a loan require payment on a monthly basis. This is also a good way for an individual considering a loan to determine how much they can afford to pay per month, and in this smaller increment than over the course of a year a very realistic picture of direct impact can be formed.
What is a “Good” DTI?
When it comes to DIT the lower the better. The “magic number,” or the number which can be thought of as a good-bad tipping point is 36%. Debt to Income ratios which come in less than 36% are deemed good and reflect an individual having financial stability, and those beyond are seen as a challenge . Unlike some standards which are federally set, banks and other loan issuing agencies are allowed to offer loans to those who don’t meet the 36% standard. There exist lenders who will grant a loan to those who have up to a 50% DTI. These loans, however, are harder to secure and often have fewer desirable terms than those offered to individuals who carry a DIT at or below the 36% benchmark.
Income to Mortgage Debt Ratio
The Income to Mortgage Debt Ratio is designed to determine what percentage of an individual’s income is dedicated to owning/purchasing their home. Calculated in much the same way as the DTI, the monthly “Frontend” ratio is determined, this includes the PITI and any homeowner association fees. The sum total of these is then divided by the monthly gross income, and lastly multiplied by 100. See below:
Monthly Frontend Ratio / Gross Monthly Income x 100 = Income to Mortgage Debt Ratio
An example of this calculation would be if an individual has a mortgage payment of $2,000 a month, and this mortgage payment includes the PITI and there are no homeowner association fees in this case. The individual then has a gross monthly income of $10,000. After plugging these figures into the equation above, the Income to Mortgage to Income Debt Ratio would be 20%.
Benchmarks of the Income to Mortgage Debt Ratio?
Based on the sciences of finances and what lenders deem suitable, an individual’s Income to Mortgage Debt ratio should be no higher than 28%. This value gives a person an idea of what a bank may offer for a home loan. An individual can also do this calculation to determine if they can afford a home and its monthly payments.
The “28/36” Golden Rule
A simple way to remember what the most desirable debt ratios are is with the 28/36 rule. This rule is a way of understanding how the DTI and Income to Mortgage Debt Ratio work together as a whole. We have already established that a DTI should be 36% or lower, and that an Income to Mortgage Debt Ratio should be less than 28%. So, the 28/36 rule describes these values. If not already obvious, the Income to Mortgage Debt Ratio is part of the DTI, part of the 36 is the 28, which implies that monthly debts beyond the Income to Mortgage Debt Ratio should only comprise 8% of the monthly gross income. That’s a mouthful, so let’s break it down using the examples we used above.
Based on the example above the individual has a gross monthly of $10,000, a Mortgage of $2,000 and total monthly debts which come to $3,000. This implies that their monthly debts are the $2,000 in mortgage and another $1,000 in other monthly debts. This might include car loan payments, student loan payments, ect. This individual would then have a Income to Mortgage Debt ratio of 20% and a DTI of 30%. With these numbers plugged into the “golden rule” they would have a 20/30 which is even better than the Golden Rule of the 28/36.
By calculating the ratios and person could plug in different values and determine for themselves what an ideal month payment would be on a mortgage and go into the application process armed with what numbers they would like or at the very least understand how different monthly payments would alter where they stand against the 28/36 Golden Rule.
Credit Scores and Credit Utilization
One of the most used terms used when discussing finances is ‘Credit Score’ and it also can be part of the success of a loan application. It is widely understood that at its core credit scores are a record of the past history of financial responsibilities and current financial situation of an individual. It gives a semi-holistic view as to the risk a borrower takes when issuing a loan, and while entire books can (and have been written) about the ins and outs of credit scores, there are a few important items about credit scores which should be understood.
- There are several different kinds of credit scores which are calculated by different companies. These scores can vary slightly and are calculated using different matrices. It is important to know which credit scores a borrower uses, and what your numbers are for those particular companies.
- Sometimes mistakes appear on the credit reports which are generating your credit scores. Take the time and effort to look at the credit scores the major companies are generating about you and make sure everything looks correct.
- Understanding what items for the good and the bad are on your credit report allows for an opportunity to improve these scores. By paying off old debt, paying down credit card debt, disputing late payments, an effort made to improve these scores will open better loan options, with better terms, and sometimes lower interest rates.
One of the misunderstood attributes to the credit score is how it is influenced by the Credit Utilization Ratio. Similar to the ratios mentioned above, this ratio is very important to understanding the loan process. UnlikeBy unlike the others, it isn’t calculated using a gross monthly income. Instead, this ratio is calculated using the amount of credit used (which could also be considered debt in the other ratios) and the total amount of credit available. For example, let’s say an individual has two credit cards, the first has a credit limit of $1,000 but only has $200 hundred left on the card until the limit has been used, and the second card has a $500 credit limit and $450 left to be used. The Credit Utilization Ratio would be calculated in the following way:
Credit Utilized (Used): $800 (card 1) + $50 (card 2) = $850
Credit Issued: $1,000 (card 1) + $500 (card 2) = $1,500
$850 / $1,500 x 100 = 56.66% Credit Utilization Ratio
An ideal Credit Utilization Ratio has been determined to be less than 30%. The example above is far outside the ideal Credit Utilization Ratio scope and this could potentially hurt them in the loan application process.
The take away however, is that having been granted credit is good. When banks and other borrowers see that an individual has been given lines of credit it offers confidence for them to do the same, but it is important to be mindful of this ratio. Say for example an individual has one credit card that is small, say $100, and they have it maxed out at the time the reports are pulled. At that moment, the individual would have a Credit Utilization Ratio of 100% which would look terrible compared to the desired 30%.
Fully understanding financial ratios and how to calculate them is vitally important when preparing to apply for a loan of any type. Not only does it give you the confidence to know what to apply for but it also allows you to understand how it will influence your monthly budget and your long-term financial wellbeing.