Debt-To-Income Ratio

What is a debt-to-income ratio?

Your debt-to-income ratio (DTI) is all your monthly debt payments divided by your gross monthly income. This number is one way lenders measure your ability to manage the monthly payments to repay the money you plan to borrow.

Different loan products and lenders will have different DTI limits. To calculate your DTI, you add up all your monthly debt payments and divide them by your gross monthly income. Your gross monthly income is generally the amount of money you have earned before your taxes and other deductions are taken out. For example, if you pay $1500 a month for your mortgage and another $100 a month for an auto loan and $400 a month for the rest of your debts, your monthly debt payments are $2,000. ($1500 + $100 + $400 = $2,000.) If your gross monthly income is $6,000, then your debt-to-income ratio is 33 percent. ($2,000 is 33% of $6,000.)

KEY TAKEAWAYS

The debt-to-income (DTI) ratio measures the amount of income a person or organization generates in order to service a debt.
A DTI of 43% is typically the highest ratio a borrower can have and still get qualified for a mortgage, but lenders generally seek ratios of no more than 36%.
A low DTI ratio indicates sufficient income relative to debt servicing, and it makes a borrower more attractive.

Understanding the Debt-to-Income Ratio

The debt-to-income ratio is of utmost importance to creditors that are considering providing financing to an individual. A higher ratio is unfavorable for creditors to see, as it indicates that a higher proportion of an individual’s income goes towards monthly debt payments.

For example, a DTI ratio of 20% means that 20% of the individual’s monthly gross income is used to servicing monthly debt payments. The maximum acceptable DTI ratio varies depending on the lender. As a guideline, it is preferable to achieve a ratio that is lower than 36%.

Front-End vs. Back-End Ratios

There are two main forms of debt-to-income ratios:

1. Front-end ratio

The front-end ratio specifies the percentage of income that goes towards rent, mortgage payments, property taxes, hazard insurance, and mortgage insurance.

2. Back-end ratio

The back-end ratio specifies the percentage of income that goes towards all recurring debt payments (including the ones above). Additional payments are added, such as credit card, car loan, student loan, and child support payments.

Overall, the front-end ratio helps measure the portion of income that goes towards housing costs, while the back-end ratio measures the portion of income that goes towards all costs.

Debt-to-Income Ratio in the Credit Analysis Process

The debt-to-income ratio is used as part of the credit analysis process to determine the credit risk of an individual. It is important to note that, for example, an individual with a DTI ratio of 15% does not necessarily possess less credit risk than an individual with a DTI ratio of 25%.

The DTI ratio only forms part of the credit evaluation of an individual; a thorough credit analysis must be conducted to correctly determine the credit risk of an individual.

Methods to Decrease the Debt-to-Income Ratio

1. Decrease monthly debt payments

By minimizing the monthly debt payments, an individual can decrease their debt-to-income ratio. For example, in a student loan, an individual has the option of repaying their principal debt to reduce the amount of interest charged.

Consider an outstanding $50,000 student loan with a monthly interest rate of 1%. Scenario one involves an individual who is not repaying their principal debt, while scenario two involves an individual who has paid down $30,000 of their principal debt.

Debt-to-Income Ratio - Scenarios

As illustrated above, as an individual pays down more of their principal debt, the monthly interest payments decrease.

2. Increase gross income

By increasing the gross income, an individual can decrease their debt-to-income ratio. The method is self-explanatory – due to the fact that the gross income is in the denominator of the ratio, an individual with a higher income would lower their debt-to-income ratio.

Consider two scenarios with a monthly debt payment of $1,500 each. However, the gross monthly income for scenario one is $3,000, while the gross monthly income for scenario two is $5,000. As such, the debt-to-income ratio would be as follows:

DTI Ratio (Scenario one) = $1,500 / $3,000 x 100 = 50%

DTI Ratio (Scenario two) = $1,500 / $5,000 x 100 = 30%

How Does Debt-to-Income Ratio Affect Credit?

Your DTI doesn't directly affect your credit scores because credit scoring models ignore income information. However, how much you owe plays a factor in your credit utilization rate, which is the second-most influential factor in your FICO® Score☉ .

Your credit utilization rate is your credit card balances divided by total credit limits. It indicates how much of your available credit you're using. Credit experts recommend keeping your utilization rate below 30%, and the lower it is, the better.

But your DTI also includes how much you owe on other types of credit accounts, including installment loans and other revolving credit lines. The more debt you're carrying on credit cards and other loans, and the higher your utilization rate, the more negatively it can impact your credit scores.

What is an ideal debt-to-income ratio?

Lenders typically say the ideal front-end ratio should be no more than 28 percent, and the back-end ratio, including all expenses, should be 36 percent or lower. In reality, depending on your credit score, savings, assets and down payment, lenders may accept higher ratios, depending on the type of loan you're applying for.

For conventional loans backed by Fannie Mae and Freddie Mac, lenders now accept a DTI ratio as high as 50 percent. That means half of your monthly income is going toward housing expenses and recurring monthly debt obligations.

Does my debt-to-income ratio impact my credit?

Credit bureaus don't look at your income when they score your credit so your DTI ratio has little bearing on your actual score. But borrowers with a high DTI ratio may have a high credit utilization ratio -- and that accounts for 30 percent of your credit score.

Credit utilization ratio is the outstanding balance on your credit accounts in relation to your maximum credit limit. If you have a credit card with a $2,000 limit and a balance of $1,000, your credit utilization ratio is 50 percent. Ideally, you want to keep that your credit utilization ratio below 30 percent when applying for a mortgage.

Lowering your credit utilization ratio will not only help boost your credit score, but lower your DTI ratio because you're paying down more debt.

How to lower your debt-to-income ratio

To get your DTI ratio under better control, focus on paying down debt with these four tips.

Track your spending by creating a budget, and reduce unnecessary purchases to put more money toward paying down your debt. Make sure to include all of your expenses, no matter how big or small, so you can allocate extra dollars toward paying down your debt.
Map out a plan to pay down your debts. Two popular ways for tackling debt include the snowball or avalanche methods. The snowball method involves paying down your small credit balance first while making minimum payments on others. Once the smallest balance is paid off, you move to the next smallest and so forth. On the other hand, the avalanche method, also called the ladder method, involves tackling accounts based on higher interest rates. Once you pay down a balance that has a higher-interest rate, you move on the next account with the second-highest rate and so on. No matter what way you choose, the key is to stick to your plan. Bankrate.com's debt payoff calculator can help.
Make your debt more affordable. If you have high-interest credit cards, look at ways to lower your rates. To start, call your credit card company to see if it can lower your interest rate. You might have more success going this route if your account is in good standing and you regularly pay your bills on time. In some cases, you may realize it's better to consolidate your credit card debt by transferring high-interest balances to an existing or new card that has a lower rate. Taking out a personal loan is another way you could consolidate high-interest debt into a loan with a lower interest rate and one monthly payment to the same company.
Avoid taking on more debt. Don't make large purchases on your credit cards or take on new loans for major purchases. This is especially important before and during a home purchase. Not only will taking on new loans drive up your DTI ratio, it can hurt your credit score. Likewise, too many credit inquiries also can lower your score. Stay laser- focused on paying down debt without adding to the problem.

Debt-to-Income Ratio Limitations

Although important, the DTI ratio is only one financial ratio or metric used in making a credit decision. A borrower's credit history and credit score will also weigh heavily in a decision to extend credit to a borrower. A credit score is a numeric value of your ability to pay back a debt. Several factors impact a score negatively or positively, and they include late payments, delinquencies, number of open credit accounts, balances on credit cards relative to their credit limits, or credit utilization.

The DTI ratio does not distinguish between different types of debt and the cost of servicing that debt. Credit cards carry higher interest rates than student loans, but they're lumped in together in the DTI ratio calculation. If you transferred your balances from your high-interest rate cards to a low-interest credit card, your monthly payments would decrease. As a result, your total monthly debt payments and your DTI ratio would decrease, but your total debt outstanding would remain unchanged.

The debt-to-income ratio is an important ratio to monitor when applying for credit, but it's only one metric used by lenders in making a credit decision.

What Are the Limitations of the Debt-to-Income Ratio?

If you transferred your balances from your high-interest rate cards to a low-interest credit card, your monthly payments would decrease. As a result, your total monthly debt payments and your DTI ratio would decrease, but your total debt outstanding would remain unchanged.

Why Is Debt-to-Income Ratio Important?

The debt-to-income (DTI) ratio is the percentage of your gross monthly income that goes to paying your monthly debt payments and is used by lenders to determine your borrowing risk. A low debt-to-income (DTI) ratio demonstrates a good balance between debt and income. Conversely, a high DTI ratio can signal that an individual has too much debt for the amount of income earned each month. Typically, borrowers with low debt-to-income ratios are likely to manage their monthly debt payments effectively. As a result, banks and financial credit providers want to see low DTI ratios before issuing loans to a potential borrower.

How Does the Debt-to-Income Ratio Differ from the Debt-to-Limit Ratio?

Sometimes the debt-to-income ratio is lumped in together with the debt-to-limit ratio. However, the two metrics have distinct differences. The debt-to-limit ratio, which is also called the credit utilization ratio, is the percentage of a borrower’s total available credit that is currently being utilized.

In other words, lenders want to determine if you're maxing out your credit cards. The DTI ratio calculates your monthly debt payments as compared to your income, whereby credit utilization measures your debt balances as compared to the amount of existing credit you've been approved for by credit card companies.