A good understanding of how to calculate the debt-to-income ratio is vital to your overall financial health. Rather than guess and hope for the best, this blog post breaks down everything you need to know about the debt-to-income ratio.
What is the debt-to-income ratio?
The debt-to-income ratio (DTI) is a financial metric that shows how well you manage debt repayment in relation to your total income.
In essence, it is the percentage of your gross monthly income that goes towards paying your monthly loan. Lenders use this to gauge your creditworthiness and risk level, affecting whether you’re approved for the loan and the interest rates you’ll be offered.
A low DTI is a sign of strong financial stability, which means you are not burdened with debt. Conversely, a high DTI can suggest financial stress and make securing loans or desirable interest rates challenging.
What is DTI Formula?
The debt-to-income ratio formula is simple: Divide your total monthly debt payments by your gross monthly income. From there, multiply by 100 to convert the number to a percentage.
For example, consider a consumer with $3,000 in monthly loan payments and $6,000 in monthly gross income. Here’s the debt ratio formula you can use:
- $3,000 / $6,000 = 0.5
- 0.5 X 100 = 50%.
- dti = 50%
With this simple formula, calculating your DTI is something you can do at any time.
How to Calculate Debt-to-Income Ratio
There are a few steps involved in understanding how to calculate your debt-to-income ratio.
First, add up your monthly loan payments. This includes mortgage or rent payments, car loans, student loans, credit card debt, and other recurring debt.
Next, determine your gross monthly income. This is your income before taxes or other deductions.
Finally, as mentioned above, divide your total monthly debt by your gross monthly income, then multiply the result by 100 to get your DTI as a percentage.
Tip: When you calculate your debt-to-income ratio, be sure you’re using up-to-date and accurate numbers.
How does DTI affect my ability to get a loan?
When comparing DTIs, lower is always better. A lower number increases the chances of loan approval at the lowest possible rate.
The lower your DTI, the more likely you are to comfortably manage your monthly loan debt on the income you earn.
In general, a DTI of 36% or less is considered favorable. On the other hand, a high DTI, usually defined as above 43%, suggests that you are carrying enough debt relative to your income. This can raise red flags for mortgage lenders, making them more hesitant to approve your loan.
What is a good debt-to-income ratio?
The term “good” in debt-to-income ratio varies from lender to lender. Generally speaking, a good DTI is less than 36%. A number in this range indicates that you have a manageable balance between debt and income.
Taking this a step further, most lenders closely examine expenses within your DTI percentage (front-end and back-end DTI). For example, if you have a DTI of 36%, they can work from the assumption that no more than 28% of your gross monthly income should go toward housing expenses. The remaining 8% should be comprised of other types of debt, such as car payments, credit card payments, personal loans, and student loans.
It is important to note that while a low DTI improves the odds of securing a loan at a competitive rate, it is only one factor that lenders consider. They also look at your credit score, credit history, credit report, credit utilization ratio, employment history and bank account balance.
What is the front-end debt-to-income ratio?
The front-end debt-to-income ratio is a subset of your total DTI. It represents the proportion of your gross monthly income that goes toward monthly housing costs such as mortgage payments, property taxes, homeowner’s insurance, and any applicable homeowner’s association dues. A lower front-end DTI generally indicates better financial balance.
What is the back-end debt-to-income ratio?
The back-end debt-to-income ratio is a comprehensive measure of your financial commitments. In addition to housing expenses, this includes all recurring monthly debt obligations such as auto loans, student loans, credit cards and child support. All loan payments are taken into account. Depending on the type of loan, at some point the loan is likely to be paid off, which will improve your ratio.
Your total debt obligations are a percentage of your gross monthly income. A lower back-end DTI is generally more favorable in the eyes of a lender.
Now that you know how to calculate your debt-to-income ratio, you can more accurately and consistently track your overall financial health.
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