In general, you will likely manage your monthly debt payments effectively if you have a low debt-to-income ratio. On top of that, banks and loan providers want to see a low DTI ratio before lending to a potential borrower.
So the goal is to keep your DTI ratio low.
However, if you’re new to managing debt and savings and wondering what a debt-to-income ratio is, why it matters, and how to calculate it, you’ll need someone to help you out.
So here’s the complete guide on the debt-to-income ratio to answer all your questions in one place!
What is the debt-to-income ratio?
Your debt-to-income ratio represents how much of your gross income is used to pay off your monthly debts. From a lender’s point of view, this report shows how much more debt you can reasonably take on, given your current income and debt situation.
There are two types of debt-to-income ratios:
This DTI measures only your monthly housing costs and how they relate to your gross monthly income. It takes your monthly rent payment into account if you are a renter. Homeownership has several other considerations, including mortgage payments, homeowners insurance, and property tax payments.
Back-end DTI measures all your monthly debt obligations, including personal loans, student loans, and credit card payments. Most banks or loan providers only do the back-end DTI calculation when evaluating your application because it showcases a more in-depth ratio of your monthly expenses.
What does a good DTI ratio look like?
A high debt-to-income ratio means trouble. Most lenders use a 43% DTI ratio as a benchmark when considering a loan. If it is above 43%, it may be harder to get a loan.
A DTI of 50% or more is even worse. If you have a limited budget, it will be more difficult to pay off your loan and cover other expenses, and you’ll get rejected for any further loans. In case of a high percentage, it either signifies that you’re paying debt on a low income or you owe a significant amount that could cause bankruptcy.
A debt-to-income ratio below 35% indicates good financial shape and shows that you can handle more debt without difficulty. Lenders prefer this because it means you would most likely be able to continue making your monthly payments even.
The ideal DTI for loans varies depending on the lender and the loan you are applying for. For example, a DTI required by the lender for a home loan differs from your DTI for a personal loan.
So it’s better to know more about the DTI ratio your lender wants and reach that certain percentage or lower before applying for a loan.
How to calculate the debt-to-income ratio?
Calculating your DTI, in a nutshell, is all about adding up your monthly debt payments and your total gross income and dividing the two figures to get a ratio. Still, there’s more, to sum up here with debt and income so let’s break down the process into three steps.
We will cover how to calculate back-end DTI since it’s used more often. However, in the first step, you can use the same steps for front-end DTI by only considering your rent or property-related debt.
1. Add up monthly debt
The first step in calculating your debt-to-income ratio is to add up all your monthly debt payments. For fixed-payment loans like rent, auto, and personal loans, you will use your regular monthly payment amount to repay the loan. Use your minimum monthly payment for non-fixed payments like credit card payments.
Your debts must include any debts listed on your credit report. Mortgage payments are calculated using full PITI (principal, interest, taxes, and insurance).
2. Add up monthly gross income.
In this step, add up your monthly income, including passive sources. Think about all of the money you earn. This will include all rental income from a property you own. If you rented out a property with a mortgage, you could only consider 75% of the rent.
3. Divide debt by income
The final step is to divide your monthly debt by the sum of your monthly gross income and multiply the answer by 100 to get a percentage. If your monthly debt is $2,100 and your monthly income is $5,000, the DTI will be 42%. How do we know it’s a good sign?
Even if you don’t plan on applying for a loan shortly, it’s a good idea to keep an eye on your debt-to-income ratio to ensure you’re prepared. To keep track of your DTI, list your recent debt payments and calculate your DTI whenever you pay off a loan.
The debt-to-income ratio is an important factor to consider when applying for credit. However, remember that it’s only one of many factors lenders consider and does not impact your financial standing or credit score.