Understanding the debt to income ratio is important if you plan to apply for any credit or loan product with a lender. Debt to income, or DTI, is a percentage that tells lenders how much money you spend on paying off debts versus how much money you have coming into your household. Lenders will review your debt to income ratio as a part of the credit application and review process when applying for any credit or loan product.
Why is the DTI ratio important?
The debt to income ratio is the percentage of your monthly income that pays off monthly debts. Lenders and banks use this figure to assess your borrowing risk. A low debt-to-income (DTI) ratio demonstrates a good balance between debt and income. A low debt to income shows the lender that you have not overextended yourself on credit and loan payments.
A high DTI ratio can signal too much debt for the amount of income earned each month. Those with lower debt to income ratios are more likely to manage their monthly debt payment and not overextend their income with loans and credit payments. As a result, banks and financial credit providers want to see low DTI ratios before issuing loans to a potential borrower.
What factors make up a DTI ratio? (Front-end and back-end ratio)
Lenders use two components to calculate your DTI ratio: front-end and back-end ratios.
- Front-end ratio – The housing ratio shows what percentage of your monthly gross income would go toward your housing expenses, including your monthly mortgage payment, property taxes, homeowners insurance, and homeowners association dues.
- Back-end ratio – This is the ratio of your debt payments (housing, auto, credit cards, education) to your income. This includes credit card bills, car loans, child support, student loans, and any other revolving debt that shows on your credit report.
Why are there two DTI ratios?
The first one is important because it shows how much money you spend on housing and shelter. Everyone needs one, which is a significant fraction of everyone’s monthly expenses. If it’s too high, you’ll be left with less for other costs that are necessary for livelihood. And therefore, less for mortgage payments too.
The second ratio is important because even if your housing expense is not that high, you might have a lot of other obligations such as credit card debt and auto loans. The more the debt as a percentage of your income, the more risk you pose to the lender.
How to calculate DTI ratio
Here’s a simple four-step formula for calculating your DTI ratio.
- Add up your monthly debts. The first step toward calculating your debt-to-income ratio is to add up all of your monthly debt payments. You will use your regular monthly payment for fixed-payment loans like rent, auto, or personal loans. For variable expenses such as credit card payments or a home equity line of credit, use your minimum monthly payment. Your monthly debts will include any obligations that are on your credit report.
- Monthly mortgage or rent payment
- Minimum credit card payments
- Auto, student, or personal loan payments
- Monthly alimony or child support payments
- Any other debt payments that show on your credit report
- Add up monthly gross income. Add up all your monthly income, including W-2 pay, 1099 income, and any income from rental properties. If the income has no documentation, such as a side job that is cash only, and you do not claim the income on taxes, the lender may not allow it.
- Divide the sum of your monthly debts by your monthly gross income (your take-home pay before taxes and other monthly deductions).
- Convert the figure into a percentage and that is your DTI ratio.
The formula: DTI = Total Monthly Debts / Gross Monthly Income
DTI Ratio Example
To demonstrate how to calculate debt to income, we will first add up all the monthly debt payments and divide them by your gross monthly income. The gross monthly income is generally the money earned before taxes and other deductions.
- Debt. Sarah earns $1500 a month for her mortgage and $100 a month for an auto loan, $400 a month for the rest of her debts so her monthly debt payments are $2,000. ($1500 + $100 + $400 = $2,000.)
- Gross monthly income is $6,000
- Divide her debt by her income, so the debt-to-income ratio is 33 percent. ($2,000 is 33% of $6,000.)
What is an ideal DTI ratio?
A debt-to-income ratio of 35% or less usually means you have manageable monthly debt payments. Debt can be harder to manage if your DTI ratio falls between 36% and 49%. For example, suppose 60% of your paycheck is paid on student loans, credit card bills, and an auto loan. There might not be much left in your budget to save or whether for an emergency, like a medical bill, appliance replacement, or major car repair.
Does the DTI ratio affect your credit score?
Your DTI ratio doesn’t directly impact your credit score since your income isn’t a factor in calculating your credit score. However, a high DTI often goes hand-in-hand with a high amount of debt, impacting your score. Amounts owed or credit utilization ratio makes up 30% of your FICO Score.
The credit utilization ratio is the outstanding balance on your credit accounts in relation to your maximum credit limit. If you can lower your amounts owed, you’ll also likely boost your credit score and decrease your DTI because you’ll be paying down debt.
Understanding debt-to-income is important because if your debt-to-income ratio is 50% or more, it probably makes sense to wait for a loan or credit until you’ve reduced the ratio. The lower your debt-to-income ratio, the safer you are to lenders — and the better your finances will be.