What is Debt-To-Income Ratio (DTI Ratio)?
For someone who doesn’t carry a lot of debt, I didn’t give Debt-to-Income Ratio a serious thought until I start lending money on peer-to-peer lending networks — i.e., Prosper and Lending Club. The truth is, DTI is important; especially in the business of borrowing and lending money.
Definition of Debt-To-Income Ratios (DTI)
Debt-to-income ratio, or DTI ratio, is the way a bank or lender determines what you can afford to borrow by determining your ability to pay back the loan. DTI ratio takes all of your monthly liabilities and divide the total by your gross monthly income. The result is a percentage called DTI ratio, and it must fall under a certain percentage for you to qualify for a loan. Generally,the maximum DTI varies by lender, loan program, and investor, but the generally accepted number is around 36%.
Two Kinds of Debt-To-Income Ratios (DTI)
This is the percentage of gross income that goes toward housing costs. For homeowners this is PITI divided by income (PITI includes Mortgage Principal, Interest, Taxes, and Insurances). For renters, this is rent divided by income (i.e., rent-to-income ratio).
This is the percentage of gross income that goes toward paying all recurring debt payments, including those included in the front ratio. Examples of other debt payments include payments for credit cards, car loan, student loan, child support, etc.
Three Reasons Why Debt-To-Income Ratios (DTI) Is Important
- Sub-prime Mortgage Meltdown — If some people in the real estate and mortgage industry didn’t get too greedy, we wouldn’t be having this problem that led to market decline, bankruptcies, unemployment, economic downturn, etc. Here’s a real life example. My wife and I were shopping for a bigger home in 2007. Our real estate agent showed us a million dollar home and suggested that we could afford a $3,900 monthly mortgage with our income. If we followed his “advice,” our mortgage would represent a front ratio of 49%. I am sure it wouldn’t take long for us to get into financial trouble and foreclose on the house.
- Credit Worthiness — One of the five C’s of credit is capacity, or the borrower’s ability to make their loan payment. This capacity is in direct correlation with DTI. In general, a borrower with higher DTI is more likely to be delinquent or default on his loan. When I lend money on Prosper and Lending Club, debt-to-income ratio (back ratio) is one of the first things I look at. In general, I try to avoid lending money to borrower with DTI greater than 36% — the suggested debt-to-income ratio that most lenders use.
- Financial Health — With widespread use of credit card and monthly payment plan, some people do not realize how deeply they are in debt. All they think about is, $10 more per month or $50 more per month, but little things do add up. Keeping track of your own DTI is a great way to keep yourself in check, and not fall into the pit of financial imprisonment. I think my friend Paidtwice said it best, “Less Debt = More Freedom“
So that’s DTI in a nutshell. I hope you enjoyed the post.
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