Debt-To-Income Ratio Calculation

What Is Your Debt-To-Income Ratio?

Your debt-to-income ratio, shortened to simply DTI, compares the amount of monthly debt payments to your monthly gross income. It divides your monthly gross income (your income before taxes are deducted) into your total monthly debt service. The higher your DTI, the more debt you have compared to your ability to repay it. The formula is as follows:

DTI = Monthly Debt Payments / Monthly Gross Income

As a general guideline, a manageable DTI is under 36 percent. Borrowers with a DTI higher than that are usually considered at risk for default because they are saddled with too much debt. So if you apply for a new loan to be added to your existing debt and you have a DTI over 36 percent, you will likely be denied.

When it comes to mortgage lenders specifically, most allow a DTI of up to 43% when you include payments on the home loan for which you are applying. This is also called the back-end ratio. You'll hear bankers use this term frequently. Additionally, your front-end ratio compares how much of your income goes to housing costs only, which should typically be no greater than 28%. These underwriting guidelines that lenders impose on those applying for home loans can change from time to time depending on how much default risk the lender is willing to take.

Also be aware that personal loan companies will consider a DTI of up to 50% since personal loans are often used to consolidate other, loans with higher interest rates. However, a DTI that high is risky for both the borrower and lender. Ultimately, the goal of debt consolidation should be to pay it down ASAP.

How To Calculate Your DTI Ratio:

To calculate your own debt-to-income ratio, first add up all your monthly debt payments, including auto loans, student loans, credit card payments, home loans and any court-ordered child support, alimony, or settlement payments. If you have debt payments that are non-monthly, add them up for the year and then divide by 12 resulting in a monthly equivalent payment.

Then, sum up all sources of your monthly gross income, such as paychecks, freelance income, rental property and investment income, alimony and child support received.

The last step is to divide the total monthly debt by the total monthly gross income. You can carry the decimal point two digits to the right to see your DTI as a whole number percentage. Setting this up in a spreadsheet is ideal.

Here's an example: Say you have two credit card payments of $50 and $75 monthly, plus an auto loan payment of $150 and a student loan payment of $300/mo. Your monthly debt obligations total $575. Let's say you earn a monthly gross salary of $4,000, plus $750 on the side from freelancing, for a total of $4,75/month.

Your DTI calculation is as follows: $575 / $4,750 = 0.12.

That’s 12%, and a DTI of 12 percent is considered quite healthy in the eyes of most lenders. In this case, you shouldn’t have any trouble managing payments or obtaining new credit in the future.

You can also work the numbers backwards in a spreadsheet. For example, if your monthly credit card payments are $200, student loan is $500 per month, and auto lease payment is $280, then your total monthly debt obligation is $980. What is the minimum income you must have to be financially healthy? Set the ratio to 36% and solve for the income which will be in the denominator. 

The calculation will look like this: $980 / Gross Income = 0.36

or Gross Income = $980 / 0.36

Solving for "Gross Income" as a variable calculates to a value of $2,722.22 or just rounded to the nearest dollar it is $2,722. 

The point of this last calculation is to show you the benefit of using this ratio to see what is the income you must generate to keep your debt under control and hopefully eventually paid down.

Avoid Student Loan Delinquency and Default

Thanks to recent legislation, defaulting on student loans can not only jeopardize credit worthiness, but also deny the defaulting borrower of Social Security benefits. A recent report reveals some of these major changes and the recent trend in defaults.

The study also segments default by the type of borrower, such as graduate vs. undergraduate students and dropping out vs. obtaining a degree. To see the complete article, click here. To learn more about avoiding student loan debt in the first place, click here.

Government Debt Isn't Rational

When comparing the debt of various governments and taking into consideration the debt-to-GDP ratio, one would rationally assume that Japan would have defaulted on it's sovereign debt by now. The reason is that their debt-to-GDP ratio is one of the highest at a whopping 200%.

But this is another display of non-rational, emotion-driven markets, since it's not the actual ability to repay that matters in the near term -- it's the perception of the ability to repay.

For the rest of this article, click here. For the Elliott Wave Principle, click here.

Alternative Pre-Payment Penalty Calculation

Some loan terms in notes calculate pre-payment penalties in terms of compensating the lender for some of or all of the interest that the lender would have earned if the borrower had not paid down the loan. This protects the lender especially when the borrower is locked in a fixed-rate loan and market interest rates drop.

From the borrower's perspective, it is wise to be aware of these loan provisions and how they can affect the cost of capital. If a borrower is convinced that his loan's rate is locked in at a historically low rate and that the market's interest rates will likely rise, then loans with this type of pre-payment penalty will be tolerable. Otherwise, borrowers should consider this type of pre-payment penalty as an additional cost.

Now, let's calculate this alternative pre-payment penalty.

Formula

Step 1:

Unpaid Principal - Yearly Pay-Off Allowance = Total Pre-Payment Principal

Step 2:

Total Pre-Payment Principal x Note Rate = Annual Interest Amount

Step 3:

Annual Interest Amount ÷ 12 months = Monthly Interest Amount

Step 4:

Monthly Interest Amount x Penalty Term = Pre-Payment Penalty

Example

Assume the following loan terms:

Unpaid Principal Balance: $150,000

Yearly Pay-Off Allowance per loan agreement: $20,000

Loan's Note Rate: 6.25%

Pre-payment Penalty Term: 6 months of interest

Calculate the following:

Step 1:

$150,000 - $20,000 = $130,000

Step 2:

$130,000 x 6.25% = $8,125

Step 3:

$8,125 ÷ 12 months = $677.08

Step 4:

$677.08 x 6 months = $4,062.48

Prepayment Penalty = $4,062.48

Common Lender Pre-payment Fee Miscalculation

It's amazing to me how some lenders will enforce loan terms that are not a part of the loan agreement or note. Worse than that, many borrowers are unaware that the lender is cheating them. A common example occurs when lenders miscalculate pre-payment penalties at the borrowers' expense.

So what's the problem? The problem is a lack of understanding of simple algebra. Here's an example: Let's say you have a mortgage of $100,000 and you want to pay down the balance (principal reduction) by mailing a $20,000 check. However, you must also pay a 3% pre-payment penalty according to your loan agreement. Many lenders will unjustifiably demand that you owe them a pre-payment penalty of $600. It sounds right because 3% of $20,000 is $600, but it is completely wrong.

The correct way to calculate a pre-payment penalty is to first realize that the pre-payment penalty is included in the $20,000 check and the rest of the $20,000 will go towards paying down the loan. The portion of the $20,000 that is the pre-payment penalty must not be used in calculating the pre-payment penalty itself. Otherwise, you're being penalized for paying a penalty.

The equation is as follows:

Pre-payment penalty + Principal Reduction = Check you're mailing

In mathematical terms, that;s:

Principal Reduction x(pre-payment penalty rate/100) + Principal Reduction = Check you're mailing

Substituting the numbers from our example:

Principal Reduction x (3/100) + Principal Reduction = $20,000

Simplifying:

.03 x Principal Reduction + Principal Reduction = $20,000

Simplifying further:

1.03 x Principal Reduction = $20,000

Now, solving for “Principal Reduction”, we get:

Principal Reduction = $20,000/1.03

Which is:

Principal Reduction = $19,417.47

Which is rounded down to the nearest penny in favor of the lender. This means that the pre-payment penalty is $582.53 ($20,000 - $19,417.47). Originally, the lender was demanding $600, which is $17.47 too much.

To keep it easy, the equation is:

Principal Reduction = Check you're mailing/(1 + (pre-payment penalty rate/100))

Sometimes this is hard to explain to someone in a bank, but there is a clever way around having to teach a bank employee basic algebra. Try simply writing two separate checks and on the memo portion of one check write “principal reduction”, and on the other write “pre-payment penalty”. Include a letter explaining that you want to pay down your loan by $19,417.47 and that you've already calculated the pre-payment penalty for them.

They'll understand this, won't question you, and you'll save $17.47 every time you do this! Of course, with larger loans or higher pre-payment penalties, you'll save even more. I hope this helps!