Banking Financial Analysis Investment Markets

Debt-to-Income (DTI) Ratio

What is a debt-to-income ratio?

Debt-to-income ratio is all people’s monthly debt payments divided by his or her gross monthly income. Your gross income is your pay before taxes and other deductions are taken out.

With the help of this ratio lenders can measure your ability to manage the payments you make every month to repay the money you have borrowed.

It is the percentage of your gross monthly income that goes to paying your monthly debt payments.

This ratio is primarily used when applying for personal mortgages (though some other personal loans depend on your DTI as well).

For small businesses, anyone wants to apply for loans; higher value is positioned on your debt service coverage ratio (DSCR).

Advantage of debt-to-income ratio

  1. It indicates how financially healthy you are.
  2. Each lender sets its own DTI requirement.
  3. It plays a large factor in how likely you are to qualify for a loan.
  4. More likely to receive an offer with better loan terms
  5. Can potentially afford to take out multiple loans
  6. Personal loan providers prefer to allow higher DTIs than mortgage lenders.
  7. Help you determine how much debt you can realistically take on.

Disadvantage of debt-to-income ratio

  1. To calculate whether a borrower is able to repay a loan, a Lenders use DTI along with credit history.
  2. High DTIs have more trouble making their payments

What is your debt-to-income ratio means for your debt?

DTI may help you resolve how you should handle your debt and whether you have too much debt.

Here’s a general rule-of-thumb breakdown:

The value from 0% to 14.9% of DTI is used to take a do-it-yourself approach to repay the debt. This can be considered using the debt avalanche or debt snowball method.

The value from 15% to 39% of DTI is primarily used for credit card debts which look into a debt management plan from a non-profit credit counselling agency. This may also used to consider credit card debt consolidation.

The value 40% or more of DTI is used to evaluate which look into debt relief options, such as bankruptcy.

 

Formula of debt-to-income ratio

Debt-To-Income Ratio

 Analysis and Interpretation debt-to-income ratio

A lower debt-to-income ratio is usually better than a better one because this means that your monthly debt payments are a smaller percentage of your monthly income.

With lower debt payments you are able to afford a larger mortgage payment or more living expenses.

Standard acceptable DTIs change over time based on the industry, geographical location, and the prime interest rate.

For example, someone purchasing a home in Southern California will probably have more flexibility in their DTI than some rural Michigan because home prices are higher in California and more likely to appreciate.

They also vary among different lenders. Remember, this is essentially a risk measurement. The lender uses this measurement to see if you can afford the mortgage.

The higher the ratio, the less likely it is that you will be able to afford the monthly payments. Some lenders are willing to issue riskier loans at a higher interest rate, while others have strict standards on what DTI they are willing to accept.

Examples of  debt-to-income ratio

Now let’s an example using the DTI formula from earlier:

Debt-To-Income Ratio

Let’s say you’re trying to use your DTI to see if you qualify for a mortgage. You pay $400/mo for your car and $100 on student loans so the total monthly debt of $500.  Your monthly gross income is $4200/month.

Now apply the formula,

Debt-To-Income Ratio = 500 / 4200

=  0.119047619047619

= 0.12 (Approx)

When you divide 500 by 4200, you’re left with 0.119047. To turn this decimal into a percentage, simply move the decimal point two places to the right and round to the nearest tenth. This gives you a current debt-to-income ratio of 12%.

Now, we’ve successfully figured a DTI ratio! Try putting your own financial information into the formula.

2 Comments

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