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 determine 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 a good way to measure your own personal finance 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 the purpose of 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%
$4,000 (Debt) ÷ $10,000 (Income) = 40% (DTI)
What Does the DTI Ratio Mean
- 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 actively work on reducing your debt
Two Kinds of Debt-to-Income 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 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.
Pinyo 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®.