Cracking the Debt-To-Income Ratio
(DTI) Code [2023 Updated]

What is a Debt-to-Income Ratio?

A debt-to-income ratio (DTI) is a financial metric used by lenders to assess a borrower's ability to repay their debts.

The calculation of the debt-to-income ratio involves the division of a borrower's total monthly debt payments by their gross monthly income, resulting in a percentage that gauges the borrower's financial position and the risk of default.

A lower percentage indicates an advantageous financial situation and a decreased probability of loan default, thereby reflecting positively on the borrower's financial stability.

For example, let's say John has a gross monthly income of $5,000, and his total monthly debt payments amount to $2,000.

To calculate John's DTI, we would divide his monthly debt payments ($2,000) by his gross monthly income ($5,000), which would give us 0.4, or 40%. This means that 40% of John's gross monthly income goes towards repaying his debts.

How to Calculate Your Debt-to-Income Ratio

Step 1: Determine Your Monthly Debt Payments

To begin, you need to add up all of your monthly debt payments. These include but are not limited to:

• Mortgage or rent payments
• Car loan payments
• Student loan payments
• Minimum credit card payments
• Personal loan payments
• Child support or alimony payments

For example, let's say you have the following monthly debt payments:

• Mortgage: $1,200
• Car loan: $350
• Student loan: $250
• Credit card: $100

Your total monthly debt payments would be: $1,200 + $350 + $250 + $100 = $1,900

Step 2: Determine Your Gross Monthly Income

Your gross monthly income is the total income you earn before taxes and other deductions. This may include:

• Salary or wages
• Tips or commissions
• Social Security benefits
• Pension or retirement income
• Rental or investment income
• Alimony or child support

For example, let's say you have the following sources of income:

• Salary: $4,500
• Rental income: $1,000

Your total gross monthly income would be: $4,500 + $1,000 = $5,500

Step 3: Calculate Your Debt-to-Income Ratio

Now, divide your total monthly debt payments by your gross monthly income:

Debt-to-Income Ratio = (Total Monthly Debt Payments / Gross Monthly Income) x 100

In our example: DTI = ($1,900 / $5,500) x 100 = 34.54%

What Payments Should Not Be Included in Debt-to-Income Ratio?

The debt-to-income ratio does not take into account certain expenses, inclusive of your utility bills, insurance premiums, healthcare costs, groceries, and other daily living expenses.

What is an Ideal Debt-to-Income Ratio?

A good DTI is generally one that is below 36%, as it signals to lenders that you have a manageable level of debt relative to your income. However, different lenders have varying standards, and some may accept higher DTI ratios depending on the type of loan and other factors.

Here is a general rule-of-thumb breakdown of DTI levels and their implications:

• DTI is 35% or Less: Low Risk

Maintaining a debt-to-income ratio (DTI) of 35% or less is regarded as favorable and demonstrates that you have a proficient handle on your finances. Applicants within this DTI range are often viewed as low-risk by creditors, allowing for smoother loan approval processes and potentially more advantageous interest rates.

• DTI is 36% to 42%: Moderate Risk

A DTI in this range is seen as moderately risky, as it suggests that a larger portion of your income is allocated to servicing debts. While you may still qualify for loans, you might face higher interest rates or more stringent lending requirements.

• DTI is 43% to 50%: High Risk

A debt-to-income ratio (DTI) exceeding 43% is regarded as high risk and suggests that a substantial portion of your earnings are devoted to servicing debt. Such a level of indebtedness can hinder you to obtain new loans or credit lines.

If you manage to qualify, it is probable that you will encounter increased interest rates and less advantageous loan terms.

• DTI is 50% or More: Very High Risk

A debt-to-income ratio of 50% or higher is considered extremely risky, as it signifies that over half of your earnings are allocated to repaying debts.

Borrowers should take prompt measures to decrease their DTI since it's tough to fulfill monthly financial commitments and obtain fresh loans or credit at this stage.

It's essential to remember that these are general guidelines, and individual lenders may have their specific standards and requirements. Nonetheless, maintaining a low DTI can significantly improve your chances of obtaining favorable loan terms and interest rates.

How to Lower Your Debt-to-Income Ratio

Map Out a Plan to Reduce Your Monthly Recurring Debt

In order to decrease your debt-to-income (DTI) ratio, it is important to begin by determining all of your current outstanding debts and the accompanying interest rates. To tackle this issue, you should develop a strategy to prioritize payment of debts with the highest interest rates, as they are the most financially burdensome to maintain.

Budgeting and tracking your expenses can help you allocate more funds toward debt repayment and reduce your DTI over time.

Avoid Taking on More Debt

While working to lower your DTI, it's crucial to avoid accumulating additional debt. This means limiting the use of credit cards, postponing large purchases that require financing, and refraining from applying for new loans or lines of credit.

Increase Your Gross Monthly Income

Another way to lower your DTI is by increasing your income. This could involve pursuing a promotion or raise at your current job, seeking additional part-time work, or developing a side hustle.

Use a Co-Signer

In terms of application for a loan, alongside reducing your DTI, incorporating a co-signer into your loan application can enhance your loan approval and potentially secure more advantageous interest rates and terms.

Nevertheless, it is important to bear in mind that nonfulfillment of payment obligations will result in the co-signer assuming responsibility for the debt.

Consider a Debt Consolidation Loan

Consolidating your debts can be beneficial as it allows you to merge several debts with high-interest rates into one loan with a lower interest rate.

This simplifies your debt management process and potentially accelerates your debt repayment, leading to a reduction in your debt-to-income ratio.

Other Strategies to Lower Your DTI

• Refinance your mortgage or other loans to secure lower interest rates or extended repayment terms, which can reduce your monthly payments.

• Negotiate lower interest rates on your credit cards or request a temporary hardship plan if you're facing financial difficulties.

• Pay off your smallest debts first (debt snowball method) to build momentum and motivation to tackle larger debts.

What Factors Make Up a DTI Ratio?

When assessing your loan eligibility, lenders may look at two different types of debt-to-income ratios during the mortgage process: front-end and back-end. Understanding these ratios can help you better prepare for the loan application process.

Front-End Ratio

The front-end ratio, also known as the housing ratio, focuses solely on your housing-related expenses in relation to your gross monthly income.

The total expenses related to your mortgage, inclusive of the amount borrowed as principal, interest charges, property taxes, homeowner's insurance (commonly referred to as PITI), and any associated homeowners association (HOA) fees, make up the overall cost.

To calculate your front-end ratio, divide your total housing expenses by your gross monthly income:

Front-End Ratio = (Total Housing Expenses / Gross Monthly Income) x 100

For example, if your housing expenses amount to $1,500 per month and your gross monthly income is $5,000, your front-end ratio would be:

Front-End Ratio = ($1,500 / $5,000) x 100 = 30%

Lenders typically prefer a front-end ratio of no more than 28%, but this can vary depending on the lender and loan type.

Back-End Ratio

The back-end ratio, also known as the total debt ratio, takes into account all of your monthly debt payments in relation to your gross monthly income. This includes your housing expenses (PITI), as well as other debts such as car loans, student loans, credit card payments, and personal loans.

To calculate your back-end ratio, divide your total monthly debt payments by your gross monthly income:

Back-End Ratio = (Total Monthly Debt Payments / Gross Monthly Income) x 100

For example, if your total monthly debt payments amount to $2,200 and your gross monthly income is $5,000, your back-end ratio would be:

Back-End Ratio = ($2,200 / $5,000) x 100 = 44%

A back-end ratio not exceeding 36% is generally regarded as ideal by lenders, but it is subject to variation based on the loan type and the lender's discretion. With certain government-backed loans such as FHA loans, higher back-end ratios of 43% or more are sometimes considered acceptable.

How Does Your Debt-to-Income Ratio Impact Your Credit?

While your debt-to-income ratio does not directly affect your credit score, it does have an indirect influence on various aspects of your credit profile. Lenders use your DTI, along with your credit score and other factors, to determine your creditworthiness and your ability to manage and repay debt.

Here are some ways your debt-to-income ratio can impact your credit:

• Loan Approval

Having a high debt-to-income (DTI) ratio implies that you are shouldering a substantial debt burden relative to your income, which could lead to your loan or credit card applications being declined.

On the other hand, maintaining a lower DTI reflects responsible management of your debt, eventually boosting your likelihood of obtaining loans and credit lines.

• Interest Rates

Lenders tend to assess borrowers with lower debt-to-income (DTI) ratios as lower risk and, as a result, offer them more competitive interest rates. However, a high DTI can translate to higher interest rates on both loans and credit cards, ultimately adding to the total cost of borrowing.

• Credit Utilization

The percentage of your available credit that you are presently using, known as credit utilization, has a substantial impact on the calculation of your credit score.

An elevated DTI implies a substantial utilization of credit, thereby exerting a negative influence on your credit score. Lowering your DIT ratio by decreasing your credit utilization can enhance your creditworthiness in return.

• Financial Flexibility

A lower DTI provides you with more financial flexibility, as you have a larger portion of your income available for other purposes, such as saving, investing, or handling unexpected expenses. This can help you avoid relying on credit to cover these costs, which can further improve your credit profile.

FAQs about Debt-to-Income Ratio

What's the difference between debt-to-limit and debt-to-income ratios?

Debt-to-limit ratio, also known as credit utilization, is the percentage of your available credit that you are currently using. It's calculated by dividing your total credit card balances by your total credit limits.

On the other hand, the debt-to-income ratio compares your total monthly debt payments to your gross monthly income.

What Are the Limitations of the Debt-to-Income Ratio?

Although the debt-to-income ratio can be a helpful tool to evaluate your level of debt, it has limitations in depicting the complete picture of your financial health. For instance, it does not take into account important aspects, inclusive of your credit score, overall net worth, or capacity to deal with unplanned expenditures.

Why is your DTI important?

Lenders rely on your DTI to gauge your creditworthiness and loan repayment capacity. A lower DTI is indicative of prudent management of your debts, boosting your opportunities to secure loans with favorable terms and attractive interest rates.

Should I apply for a home loan with a high DTI?

It's generally advisable to lower your DTI before applying for a home loan, as a high DTI can result in loan rejections or less favorable terms and interest rates. However, if you have a strong credit score and other compensating factors, you may still qualify for certain loan programs even with a high DTI.