What is the debt to income ratio (DTI)?
The debt-to-income ratio (DTI) is a personal finance measure that compares an individual’s monthly debt payments to their monthly gross income. Your gross income is your salary before taxes and other deductions are taken. The debt to income ratio is the percentage of your gross monthly income that is used to pay your monthly debts.
Key points to remember
- The debt-to-income ratio (DTI) measures the amount of income a person or organization generates to service a debt.
- A DTI of 43% is generally the highest ratio a borrower can have and still get a mortgage, but lenders generally look for ratios no higher than 36%.
- A low DTI ratio indicates sufficient income about debt service, and makes the borrower more attractive.
DTI formula and calculation
The DTI ratio is one of the metrics that lenders, including mortgage lenders, use to measure an individual’s ability to manage their monthly payments and repay their debts.
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&text{DTI} = frac{ text{Total Monthly Debt Payments} }{ text{Gross Monthly Income} } end{aligned}DTI= Gross monthly income Total monthly debt payments
- Total your monthly debt payments, including credit cards, loans, and mortgages.
- Divide the total amount of your monthly payments by your gross monthly income.
- The result gives one decimal, so multiply the result by 100 to get your DTI percentage.
What does the DTI ratio tell you?
A low debt-to-income ratio (DTI) demonstrates a good balance between debt and income. In other words, if your DTI ratio is 15%, it means that 15% of your monthly gross income is spent on paying off your debts each month. Conversely, a high DTI ratio may indicate that an individual is in too much debt for the amount of their monthly income.
In general, borrowers with a low debt-to-income ratio are likely to manage their monthly debt payments effectively. Therefore, banks and financial credit providers want to see low DTI ratios before granting loans to a potential borrower. The preference for low DTI ratios makes sense because lenders want to be sure that a borrower is not over-leveraged, that is, they have too much debt to repay relative to their income.
Generally, 43% is the highest DTI ratio a borrower can have and still get for a mortgage. Ideally, lenders prefer a debt-to-income ratio below 36%, with no more than 28% going towards servicing a mortgage or paying rent.
The maximum DTI ratio varies from lender to lender. However, the lower the debt-to-income ratio, the more likely the borrower is to be approved, or at least considered, for the credit application.
DTI ratios vs. debt/limit ratios
Sometimes the debt-to-income ratio is grouped with the debt-to-limit ratio. However, these two parameters have distinct differences.
The debt-to-limit ratio, also known as the credit utilization ratio, is the percentage of a borrower’s total available credit that is currently utilized. In other words, lenders want to determine if you are using your credit cards to the max. The credit utilization ratio calculates your monthly debt payments relative to your income. The credit utilization ratio measures the balance
of your debts compared to the amount of existing credit for which you have been approved by the credit card companies.
Debt-to-income ratio limitations
Although important, the DTI ratio is only one of the financial ratios or measures used to make a credit decision. A borrower’s credit history and credit rating also weigh heavily in the decision to extend credit. A credit score is a numerical value of your ability to repay debt. Several factors have a negative or positive impact on a score, and they include late payments, delinquencies, the number of open credit accounts, credit card balances against their credit limits, or the use of the credit.
The DTI ratio does not distinguish between different types of debt and the cost of servicing those debts. Credit cards carry higher interest rates than student loans, but they are lumped together in the calculation of the DTI ratio. If you transferred your balances from your high-interest cards to a low-interest credit card, your monthly payments would decrease. Therefore, your total monthly payments and your DTI ratio would decrease, but your total debt would remain unchanged.
The debt-to-income ratio is an important ratio to monitor when applying for credit, but it is only one of the metrics used by lenders to make a credit decision.
