What Is the Debt-to-Income (DTI) Ratio?
The debt-to-income (DTI) ratio is the percentage of your gross monthly income that goes to paying your monthly debt payments. This ratio is crucial for lenders in assessing your borrowing risk.
Key Takeaways
- The debt-to-income (DTI) ratio measures the percentage of a person’s monthly income that goes to debt payments.
- A DTI of 43% is typically the highest ratio a borrower can have and still get qualified for a mortgage, but lenders generally seek ratios of no more than 36%.
- A low DTI ratio indicates sufficient income relative to debt servicing, making a borrower more attractive.
Understanding the Debt-to-Income (DTI) Ratio
A low DTI ratio reflects a good balance between debt and income. For instance, a DTI ratio of 15% means that 15% of your monthly gross income goes to debt payments each month. In contrast, a high DTI ratio suggests that an individual has too much debt relative to income. Borrowers with low DTI ratios are more likely to effectively manage their monthly debt payments, making them attractive to lenders who prefer low-risk borrowers.
As a guideline, 43% is the highest DTI ratio a borrower can have to still qualify for a mortgage. Ideally, a DTI ratio should be lower than 36%, with no more than 28%-35% allocated to a mortgage payment.
DTI Formula and Calculation
The DTI ratio is a financial measure that compares monthly debt payments to monthly gross income (income before taxes and deductions). Lenders use the DTI ratio to evaluate a borrower’s ability to manage monthly payments and repay debts.
Debt-to-Income Ratio Limitations
While the DTI ratio is significant, it is not the sole metric used in credit decisions. Factors like credit history and credit score also weigh heavily. Credit scores, which measure the ability to repay debt, can be influenced by payment history, delinquency, number of credit accounts, and credit utilization.
The DTI ratio does not differentiate between types of debt or their servicing costs. High-interest credit cards and low-interest student loans are grouped together in this calculation. However, transferring high-interest debt to low-interest credit options can affect monthly payments and, thereby, the DTI ratio without impacting overall debt.
Debt-to-Income Ratio Example
John is applying for a loan and needs to calculate his DTI ratio. His monthly bills and income are as follows:
- Mortgage: $1,000
- Car loan: $500
- Credit cards: $500
- Gross income: $6,000
John’s total monthly debt payment is $2,000:
$$ $2,000 = $1,000 + $500 + $500 $$
John’s DTI ratio is:
$$ 0.33 = $2,000 ÷ $6,000 $$
In simpler terms, John has a 33% debt-to-income ratio.
How to Lower a Debt-to-Income Ratio
To lower your DTI ratio, either reduce your monthly recurring debt or increase your gross monthly income.
Using John’s example, if his debts stay the same but his income increases to $8,000, his new DTI ratio would be:
$$ $2,000 ÷ $8,000 = 0.25 ext{ or } 25% $$
Alternatively, if John pays off his $500 car loan, his total debt would drop to $1,500, changing his DTI ratio to:
$$ $1,500 ÷ $6,000 = 0.25 ext{ or } 25% $$
If he both reduces debt to $1,500 and increases income to $8,000, the new DTI ratio would be:
$$ $1,500 ÷ $8,000 = 0.1875 ext{ or } 18.75% $$
Why Is Debt-to-Income Ratio Important?
The DTI ratio helps lenders evaluate the balance between an Applicant’s income and incurred debts, giving insight into borrowing risk. Low DTI ratios often signify effective debt management, which is preferred by lenders for approving loans.
What Is a Good Debt-to-Income Ratio?
A DTI ratio of up to 43% qualifies for a mortgage, though lenders prefer it below 36%, with no more than 28%-35% designated for mortgage payments. Ratio expectations vary, but lower DTI ratios generally improve loan approval chances.
Real-World Examples of DTI Ratio
For instance, Wells Fargo considers DTI ratios up to 35% as manageable, ratios between 36% and 49% needing improvement, and ratios 50% or higher limiting financial flexibility and borrowing options.
Limitations of the Debt-to-Income Ratio
The DTI ratio does not account for various debt types and their servicing costs. Consequently, strategies to lower one’s monthly payments can affect DTI without changing the outstanding debt.
Difference Between Debt-to-Income Ratio and Debt-to-Limit Ratio
Although related, the Debt-to-Income ratio differs from the Debt-to-Limit ratio, which measures credit utilization. The latter evaluates how much of a borrower’s credit line is being used, whereas DTI calculates income percentage going to debt payments.
Related Terms: Credit Utilization Ratio, Debt-to-Limit Ratio, Credit Score.
References
- Consumer Financial Protection Bureau. “Debt-to-Income Calculator”. Pages 2–3.
- Wells Fargo. “What Is a Good Debt-to-Income Ratio?”
