Debt-to-Income Ratio, or DTI ratio, is how a bank or lender determines what you can afford to borrow. It is a way to assess your ability to pay back the loan based on your income and other debt obligations. If your DTI ratio is too high, then you’re a risky borrower and may not qualify for the loan. It is also an excellent way to measure your financial health.
How to Calculate Your Debt-to-Income Ratio
1. Add Up Your “Debt”
First, you want to add up all your monthly bills that are considered debts, for example:
- Rent or mortgage payment
- Alimony or child support payments
- Student loan payments
- Car loan payments
- Credit card payments (use the minimum monthly payment amounts not what you actually pay)
- Other debts
Other non-debt expenses like utilities, groceries, gas, taxes, etc. do not count for this calculation.
2. Add Up Your “Income”
Second, add up your gross monthly income (before taxes and withholdings, and contributions to 401(k), HSA, FSA, etc.). If you have side hustle income sources, you can add them too (assuming everything is documented).
3. Divide Your “Debt” over your “Income”
The result is your DTI Ratio. For example, if your total monthly debt payment is $4,000 and your total gross monthly income is $10,000, then your DTI ratio is 40%
DTI = Debt ÷ Income
$4,000 (Debt) ÷ $10,000 (Income) = 40% (DTI)
What is a Good Debt-to-Income Ratio Ratio?
- DTI ratio under 36% is good, and you will qualify for most loans given other conditions are acceptable.
- DTI ratio between 36% to 49% is an indication that you should not borrow any more money and needs to work toward getting it down below 36%. However, you will still qualify for some loans and mortgages.
- DTI ratio above 50% is risky. You need to work on reducing your debt actively
Two Kinds of DTI Ratio
This is the percentage of gross monthly 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 basically the calculation demonstrated in the last section. This is the percentage of gross income that goes toward paying ALL recurring debt payments.
Three Reasons Why Debt-to-Income Ratio 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 house 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 a higher DTI is more likely to be delinquent or default on his loan. When I lend money on Prosper and Lending Club, the debt-to-income ratio (back ratio) is one of the first things I look at. In general, I try to avoid lending money to a borrower with DTI higher than 36% — the suggested debt-to-income ratio that most lenders use.
- Financial Health — With the widespread use of credit cards 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.
Pinyo Bhulipongsanon is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.
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.
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… Read more »
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?
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
I am completely frustrated! Wanting to take advantage of the low rates we applied for a fixed mortgage. (In an ARM) We have great credit, little to no debt, still have quite a bit of equity in our home and two incomes. However, we are both self -employed and have a great CPA who writes off as much as possible for taxes. So when it comes to our adjusted income our DTI shows us at 52%. Why can’t they consider that self-employed people write off as much as possible to avoid paying too much in taxes! It is obvious that… Read more »
I hate to say it, but you win some and you lose some. I am not saying that you’re wrong to write off as much as possible to reduce your taxes. But when you write off a lot to lower your income, this is one of the consequences. It seems like that’s your best bet since prepayment won’t help you when the teaser rate expires.
I applied for a home equity loan at a local credit union and was denied based on a DTI of 50%. I own a rental property which i make payments on of $1000.00 per month (owe 90K), but take in $2000.00 a month in rental income. I also have a mortgage payment on my home. These two mentioned is all the debt i owe. The lender stated the debt on the rental property was the reason my DTI was to high. I asked why the income, 24K, per year was not used in the calculation, but only the debt. I… Read more »