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.
