Definition and Examples of Debt-to-Income Ratio
The debt-to-income ratio calculation shows how much of your debt payments consume your monthly income. This information helps both you and lenders figure out how easy it is for you to afford monthly expenses. Along with your credit scores, your debt-to-income ratio is an important factor for getting approved for a loan.
A debt-to-income ratio, also known as a DTI ratio, is quoted as a percentage. For example, you might have a debt-to-income ratio of 25%, meaning one-quarter of your monthly income goes toward debt repayment. If your income is $4,000 per month, 25% of that would be $1,000 of total monthly debt payments.
How Do You Calculate Debt-to-Income Ratio?
To calculate your current debt-to-income ratio, add all of your monthly debt payments, then divide your monthly debt payments by your monthly gross income.
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Note
Multiply your income by a target debt-to-income level, such as 30%. The resulting dollar amount is an upper limit on your total monthly payments if you want to meet that target.
Monthly debt payments include the required minimum payments for all your loans, including:
- Auto loans
- Credit card debt
- Student loans
- Home loans
- Personal loans
The gross monthly income used in the calculation equals your monthly pay before any deductions for taxes or other items on your paycheck.
How Your Debt-to-Income Ratio Works
A debt-to-income ratio helps lenders evaluate your ability to repay loans. If you have a low ratio, you may be able to take on additional payments.
Assume your monthly gross income is $3,000. You have an auto loan payment of $440 and a student loan payment of $400 each month. Calculate your current debt-to-income ratio as follows:
Divide the total of your monthly payments ($840) into your gross income:
$840 debt payments / $3,000 gross income = .28 or 28% debt-to-income ratio.
Now, assume you still earn $3,000 per month gross, and your lender wants your debt-to-income ratio to be below 43%. What is the maximum you should be spending on debt each month? Multiply your gross income by the target debt-to-income ratio:
$3,000 gross incomex 43% target ratio = $1,290 or less monthly target for debt payments
Total debt payments lower than the target amount mean you’re more likely to get approved for a loan.
What Is the Maximum Allowable DTI?
The specific debt-to-income requirements vary from lender to lender, but conventional loans often range from 36% to 45%.
For your mortgage to be a qualified mortgage, the most consumer-friendly type of loan, your total ratio must be below 43%. With those loans, federal regulations require lenders to determine you have the ability to repay your mortgage. Your debt-to-income ratio is a key part of your ability.
Lenders may look at different variations of the debt-to-income ratio: the back-end ratio and the front-end ratio.
Back-End Ratio
A back-end ratio includes all your debt-related payments. As a result, you count the payments for housing debt as well as other long-term debts (auto loans, student loans, personal loans, and credit card payments, for example).
Front-End Ratio
The front-end ratio only includes your housing expenses, including your mortgage payment, property taxes, and homeowners insurance. Lenders often prefer to see that ratio at 28% or lower.
Note
If monthly payments are keeping you from making progress on financial goals, consider working with a nonprofit credit counseling agency. A professional can help you make a plan and take control of your debt.
Improving Your DTI Ratio
If a high debt-to-income ratio prevents you from getting approved, you can take the following steps to improve your numbers:
- Pay off debt: This logical step can reduce your debt-to-income ratio because you’ll have smaller or fewer monthly payments included in your ratio.
- Increase your income: Getting a raise or taking on additional work improves the income side of the equation and reduces your DTI ratio.
- Add a co-signer: Adding a co-signer can help you get approved, but be aware that your co-signer takes a risk by adding their name to your loan.
- Delay borrowing: If you know you’re going to apply for an important loan, such as a home loan, avoid taking on other debts. You can apply for additional loans after the most important purchases are funded.
- Make a bigger down payment: A large down payment helps keep your monthly payments low.
In addition to improving your chances of getting a loan, a low debt-to-income ratio makes it easier to save for financial goals and absorb life’s surprises.
Key Takeaways
- A debt-to-income ratio provides a quick view of your monthly finances.
- A low ratio indicates you are spending a small portion of your income on debt.
- Lenders may set maximum limits on your debt-to-income ratio.
- You can improve your ratios by paying down debt, borrowing less, or earning more income.
