What is Debt-To-Income Ratio (DTI) and Why Does It Matter?
By Pinyo • Jan 29th, 2008 • Category: Credit and DebtFor 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.
Two Kinds of Debt-To-Income Ratios (DTI)
- Front ratio — This is the percentage of gross income that goes toward housing costs. For renters, this is rent divided by income. For homeowners this is PITI divided by income (PITI includes Mortgage Principal, Interest, Taxes, and Insurances).
- Back 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 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%.
- 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.
More about Debt-To-Income Ratio:
- How to Calculate Debt-to-Income Ratio @ LifeSpy
- What’s Your Debt-To-Income Ratio? @ Investopedia
- Do You Have Too Much Debt? Calculating Your Debt to Income Ratio @ About.com
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Shouldn’t frugality be worth something? A frugal person with a high DTI ratio can have greater capacity and be a better risk than a non-frugal person with a lower DTI ratio.
I agree, MW. But I’m afraid it’s hard to prove frugality. I think that’s the benefit of Prosper and such. Tricia at Blogging Away Debt, for instance, was able to share her blog with people who might want to fund her. Technically it’s not proof of her frugality because bloggers can lie or mislead. But if she’s telling the truth (which I assume she is) she’s certainly the kind of person you want to lend to.
But banks are less likely to accept that kind of thing.
I read some of the Prosper discussion forums and got the impression that lenders look unfavorably toward people with very low incomes, no matter how frugal they are.
this is definatley an interesting topic my partner an i have just purchased our first property and neither earn a huge amount but we live frugally. are we looked a favourably because we have the property? or negative because we don’t spend much on anything else except essential?
At one point, before we started paying off our debt, our DTI was reversed. So basically the amount of money that we were paying out was less than we were bringing in. That was a fun time .
The thing with DTI, is that it doesn’t really matter how frugal you are. The fact is that you have a high amount of debt compared to your income. While being frugal helps you pay it all off every month, the bank still sees that high amount of debt, and worries that you may not be able to pay it off one day.
We use the back ratio, all debt payments against gross income.
Banks here consider 33% as the maximum for a credit worthy person.
We computed ours late last year and it was at the “yikes” level.
I think I should have computed this every time we considered a loan.
Since rent is half my income, my ratios are toast right off the bat.
If you’re going to be broke the rest of ytour life, how important is frugality? Does it make a huge difference whether you die with $X debt or $2X debt?
I don’t think frugality matters in term of DTI. It’s a straightforward mathematical calculation. Frugality only matters in a sense that you may be able to pay your debt down faster if you are frugal, thus improving your DTI.
Spend less, save more, enjoy life. Everything else is secondary. If you’ve got yourself into debt, stop spending. That should always be the primary advice.
Pinyo, you’ve just summarised in a nutshell what a financial adviser this week tried to explain to me in 40 minutes! Thanks for the post