What is Debt-to-Income Ratio?

July 24, 2019 9:00 am What is Debt-to-Income Ratio Published by

You’ve probably heard some older people talk about the importance of staying debt-free. While it may be tempting to ignore the old folks, there is something to this attitude that is worth considering. Racking up debt is probably the easiest and fastest way to ruin your credit, making it very difficult to obtain a loan for any purpose.

In this article, we will attempt to educate you about one of the most important criteria used by lenders to determine your eligibility. In some ways, your debt-to-income ratio (or DTI) is even more important than your credit score. If you ever plan to get a loan for any reason, this information will be important to you.

What Is Debt-To-Income Ratio?

Debt-to-income ratio, also called DTI, is a way of measuring a person’s assets against their debt in order to determine how financially trustworthy they are. The name tells us virtually everything we need to know here, as this ratio is simply a comparison between your income and your debt.

How Do I Find My Debt-To-Income Ratio?

Before you learn how to calculate your DTI, you need to learn about the two types of DTI, as each one is calculated according to a different formula. The two types of DTI are referred to as “front-end” and “back-end.” There are numerous websites that offer calculators that can determine your DTI numbers, but they are unnecessary for anyone who knows how to use a calculator.

Front-end DTI is the more specific and targeted of the two options. This ratio is normally related to one specific expense rather than being an overall measure of a person’s credit. To figure out your front-end DTI, add up all your housing expenses. This should include things like mortgage payments, home insurance, mortgage insurance, liens against the property, etc. Add up all these expenses for an entire month.

Now, figure out your total gross income (meaning your income before taxes) for the month. That shouldn’t be too hard, as the information can easily be found on your most recent tax return. Now, all you have to do is divide your total home expenses by your total gross income. The resulting number is your percentage of debt in relation to your income, The lower your number, the better. For most loans, it is advisable to have a front-end DTI of no more than 28%.

  • To Figure Front-End DTI: Total monthly home expenses / gross monthly income= DTI (%)

Back-end DTI is another story. This one doesn’t focus on a specific kind of debt. Instead, it takes all of your debt into account. You will need to start by adding up your total monthly debt expenses. This includes any debt from any source, so don’t skip anything. now figure out your gross monthly income. The easiest way to do this is by looking at your check stubs. Average the numbers if there is a lot of variation from month to month. Now take that number and divide it by your gross monthly income.

  • To Figure Back-End DTI: Total monthly debt payments / gross monthly income= DTI (%)

What Will Be Affected By My DTI?

Your DTI will mostly affect your ability to qualify for loans. Whether it’s a home loan, a business loan, or just a standard bank loan, every lender will want to get a look at your DTI. Lenders really need this information, because it will tell them how likely it is that you will pay your debts.

Look at it from the lender’s perspective. They don’t know you, and they have no reason to trust you. Therefore, they have to make a judgment based on your personal financial history. It also gives the lender a better picture of your overall financial situation. They have to answer two questions when evaluating your loan application: Is this a person who pays their debts, and can they afford to do so? After all, customer honesty won’t be enough if the person simply cannot pay.

How To Lower Your DTI:

Lowering your DTI is a simple proposition on the surface. You simply need to decrease your debt, increase your income, or (preferably) both. This might seem like an oversimplification, but there are many ways in which these results can be achieved. Here are a few examples:

  • Look for a better-paying job
  • Look for a second job
  • Whenever you make a payment on your debts, make sure that you are at least putting something on the principal
  • Change your lifestyle so that you can live more cheaply
  • Do your best to avoid all credit-based purchases.
  • Turn your hobby into a business

What Is Considered To Be A Good DTI?

This is a hard question to answer, as each lender has their own rules. However, it is generally true that anything over 40% is considered problematic. Anything over 50% is considered excessive and will probably get you disqualified from any loan. However, those who are on the lower end can sometimes get approved, though their interest payments will probably be a little bit higher as a result. So, the rule of thumb here is: “Half or more, out the door.” In other words, a DTI of more than 50% will probably result in a quick denial.

Conclusion

Right now, you might be kicking yourself and wondering why you’ve never heard about this in the past. It is indeed odd that something this important is not understood by a greater number of people. At the same time, this is a good thing for you. Having uncommon knowledge tends to be an advantage, and this knowledge is no exception. By understanding how the process works, you should be better able to negotiate that process and avoid the many snags that can arise. We thank you for reading this article, and we invite you to show your appreciation by filling out the contact form below.