Debt to income (DTI) is a ratio measuring an individual’s ability to pay their debts. It compares the individual’s monthly debt payments to his or her gross monthly income. The ratio is used by creditors to estimate how probable borrowers are to pay monthly payments on time until the debt is paid.
Debt to income ratio is one of the most important tools creditors need to decide whether to approve or not loans to individuals. The higher the ratio, the more unfavorable an individual is in the eyes of lenders. This measurement is only a part of a bigger process to determine the credit risk or the creditworthiness of an individual since DTI alone is not an all-powerful tool that doesn’t need a more thorough analysis.
Debt to Income Ratio Formula
$$DTI = \dfrac{\text{Monthly Debt Payments}}{\text{Gross Monthly Income}}$$
To find the monthly debt payments, add all of an individual’s debts. These include mortgage, credit cards, loans, insurances, etc. On the other hand, gross monthly income is the gross amount of monthly income an individual receives before taxes and other deductions. DTI ratio is expressed as a percentage.
People sometimes mistake the DTI ratio as the debt to limit ratio which compares an individual credit usage to their total available credit. This is entirely different from DTI that measures total debt vs. total income.
As mentioned before, debt to income is simply a small part, albeit an important one, to a larger process creditors use to determine the capability of an individual to repay debts. This larger process is often referred to as credit analysis. Credit analysis is implemented to gauge the borrower candidates’ credit risk—the probability of an entity (in this case, an individual) failing to pay the required payments on loans due to the entity’s fault.
The lower the ratio, the better it is for individuals who want a loan to be issued by lending institutions. There’s no universal maximum value of DTI acceptable by lenders, but a ratio lower than 36% is generally acceptable. Having said that, creditors may still give loans to people who have a higher ratio than 36% if they are deemed to have a good credit based on the credit analysis.
On the contrary, creditors may not approve of an individual’s loan request, even if they have a relatively low DTI ratio. DTI is not the only variable to determine credit risk. So while the individual may have a good DTI, he or she may still be deemed risky because of bad credit history.
Debt to Income Ratio Example
Hannah, an office worker, wants to apply for a loan to one of the banks that provides lending products. The bank needs to implement analysis to indicate the creditworthiness of Hannah, debt to income is one of the instruments used.
Hannah currently needs to pay $1,250 a month as mortgage fees for her house and her car. Furthermore, she also has a monthly credit card payment of $200, $150 for insurance, and $400 of additional debt. Her monthly wage before tax is $6,500. What is her debt to income ratio?
Let’s break it down to identify the meaning and value of the different variables in this problem.
- Monthly Debt Payments = 1,250 + 200 + 150 + 400 = 2,000
- Gross Monthly Income = 6,500
Now let’s apply the values to our variables and calculate the debt to income ratio:
$$DTI = \dfrac{2{,}000}{6{,}500} = 30.77\%$$
In this case, the debt to income would be 30.77%.
From this result, we can see that Hannah’s DTI is still generally within the acceptable range. However, to accept her application, the bank won’t just use DTI to measure the credit risk of Hannah. They will need to further analyze her credit history.
Debt to Income Ratio Analysis
Debt to income is one of the most important tools for creditors when intending to issue a loan for an individual. DTI is often the determining factor of whether someone will be able to get a loan or not. However, DTI is not the only measurement creditors use to gauge the credit risk of an individual.
Aside from DTI, creditors also need to examine individuals’ credit history. They may have low DTI but, at the same time, they may also tend to be negligent in paying their debts. That’s why creditors don’t rely exclusively on DTI but also other factors such as credit score, which is a numerical value that shows the borrower’s creditworthiness based on numerous factors.
Individuals can try to lower their DTI ratio in various ways. The most straightforward method to do so would be increasing their gross monthly income. Since the gross monthly income is the denominator, it goes without saying that increasing it will also lower the ratio. Another way to do this is by settling any outstanding debts or at least paying off parts of them. For instance, you can pay off the principal of your car mortgage early. This will reduce the monthly fee you need to spend, assuming the interest rate is not fixed.
Debt to Income Ratio Conclusion
- The debt to income is a ratio between an individual’s total debt and total income, which indicates the individual capability to pay his or her debts.
- The formula for debt to income requires two variables: monthly debt payments and gross monthly income.
- The debt to income ratio is expressed as a percentage.
- Different lending institutions have different guidelines at which to define in what range the potential borrowers’ DTI ratio is considered acceptable. However, 36% or less is generally ok.
- Individuals can lower their debt to income ratio by increasing their monthly income or reducing their monthly debt payments.
Debt to Income Ratio Calculator
You can use the debt to income calculator below to quickly calculate the ratio between an individual’s total debt and total income by entering the required numbers.