The debt-to-income ratio (DTI) is one of the essential ratios when applying for a mortgage. But many times, people are confused about how it’s calculated and why they should care about this number. We’re here to demystify this important ratio.
A Basic Definition
In simple terms, your debt-to-income ratio is the percentage of your monthly gross income that goes towards making minimum debt payments. To calculate it, divide the total amount of your minimum debt payments by your monthly gross income.
So let’s say you pay $2,500 towards debt every month, and your gross monthly income is $7,500. Your DTI is about 33 percent. If you pay that same $2,500 on a $10,000 monthly income, your DTI is only 25 percent.
As you can see, calculating your debt-to-income ratio is actually pretty simple. But actually using it can be a bit more complex.
What is DTI Used For?
Your debt-to-income ratio should be a financial factor that you track for your own purposes. Having a lower DTI will make it easier to live within your means. Plus, the lower your DTI, the more money you have left over to devote towards saving, investing, or just having some fun with your hard-earned cash.
But your DTI isn’t just an important number for your own purposes. Lenders also use it to decide whether you qualify for a mortgage or mortgage refinance, or whether they’ll extend you other types of credit.
In other words, lenders are particularly concerned with how much debt you carry versus your monthly income. They care more about debt-to-income ratio than your total amount of outstanding debts or your total monthly payments. This makes sense, if you think about it.
On a $5,000 a month income, $2,500 in minimum payments is significant. If you may $10,000 a month, you can likely handle that $2,500 obligation easily. In the first scenario, potential new lenders will worry about your ability to make payments on new debts. In the second scenario, lenders may be practically pounding down your door to loan you money, since you’re likely in a good place financially.
One Thing DTI Is Not Used For
One myth about debt-to-income ratios is that your DTI directly affects your credit score. This is false.
Your credit score is based on your credit report. And one thing that doesn’t appear on your credit report is your income. That means your credit score doesn’t include your income or any factors (like debt-to-income ratio) based on your income.
The reason this myth persists is likely that one big part of your credit score is your debt-to-credit ratio. This is how much total debt you have versus how much credit you have available. It’s not the same thing as your DTI.
In fact, it’s possible to have a great debt-to-income ratio and a terrible debt-to-credit ratio, or vise versa. Here’s an example:
Jack earns an excellent income and has never gone into more debt overall than he can handle. But he recently went on a vacation and maxed out his only credit card. He’s carrying a $7,500 balance on a $10,000 credit limit–a 75 percent debt-to-credit ratio. Not good!
But Jack’s total debt-to-income ratio is still well within the range of great. With the new, higher credit card payment, as well as his home loan–his only other form of debt–he only has $2,500 in monthly payments. On his $10,000-a-month income, that’s considered a great debt-to-income ratio.
Alice, on the other hand, makes a point to never carry a credit card balance. With a $5,000 limit between her two cards and a $0 balance, her debt-to-credit ratio is excellent. But between her student loan payments, car payments, and house payment, she pays $2,000 a month in minimum payments. On her $5,500-a-month income, that’s about a 36 percent debt-to-income ratio. Most lenders are uncomfortable with her monthly obligations, even if her credit score is great.
As you can see, DTI and debt-to-credit are calculated differently. And they’re used in different ways.
For most people, debt-to-income ratio is indirectly related to their credit score, though. The higher your DTI, the more likely you are to drop the ball on debt payments. This can tank your score pretty quickly! And you may have a high DTI because you’ve run up high balances on credit cards. This can also drop your credit score.
But, again, your debt-to-income ratio does not directly affect your FICO–or any other–credit score.
How Do Lenders Use DTI?
Lenders look at a host of factors when determining whether or not to extend you credit. One of these factors is your debt-to-income ratio. But what, exactly, are they looking for? Before we talk about that, we need to delve into the two types of debt-to-income ratios: front-end DTI and back-end DTI.
Front-End vs. Back-End DTI
Your front-end DTI only looks at your monthly housing payment. If you own, this is your mortgage payment. If you rent, this is your rent payment. Your back-end DTI includes all of your monthly debt and housing payments.
So let’s break out how this would look. Here’s the math for a fictional consumer, Abigail:
- Mortgage Payment: $1,500
- Credit Card Minimums: $150
- Car Payment: $300
- Student Loans: $250
- Personal Loans: $50
- Total: $2,250
Abigail’s monthly gross income is $7,500. So her front-end DTI is 20 percent. Her back-end DTI is 30 percent.
Banks calculate these ratios both ways for a reason. Often times, housing costs are more inflexible–and more essential–than other types of debt. So lenders need to make sure you can easily handle your monthly housing obligations. But they also care about your overall obligations and your ability to pay them. So now that you know how these things are calculated, let’s look at what banks prefer to see.
How Much Debt is Too Much?
Most banks and lenders require both front-end and back-end DTI to fall under a certain percentage. But they’ll often put more weight on the back-end DTI. These numbers are especially important when it comes to mortgage loans. With these loans, in particular, lenders will look at what your DTI ratios would be with the loan you’re asking for.
For instance, Abigail in our above example is in pretty good shape. But if she applies for a mortgage with a $3,000 monthly payment, she might have a bit of trouble, as her front-end ratio would creep up to 40 percent of her income. Lenders usually like to see that your front-end DTI is in the 20 to 28 percent range or less.
Different lenders will have different guidelines. But in general, these back-end DTI guidelines are close to what lenders will assume:
- 20% or less is generally considered excellent.
- 20% – 36% is a good ratio and will most likely not be a cause for concern.
- 36% – 40% starts to make you a questionable candidate and lenders may need an explanation of why your DTI is so high.
- 40% or higher is a huge “no-no.” This is usually a deal breaker for the majority of lenders.
Beware of Mortgage Lenders’ Calculations
Mortgage lenders are often fine with a total debt-to-income ratio of around 36 percent. So you may be able to qualify for a mortgage that would push you into this range. But that monthly payment level may not actually be comfortable for your budget.
So it’s important to note that just because you qualify for a mortgage doesn’t mean that it’s a good idea. You should always look at lenders’ guidelines as the absolute maximum. But if you’re anything like most people, putting over a third of your gross income (not even your take-home pay!) towards a mortgage payment can be tough. That doesn’t leave a lot of wiggle room for other expenses or emergencies.
Just keep this in mind, and take mortgage lenders’ calculations with a grain of salt. Always have a look at your actual budget based on take-home pay to ensure you can comfortably handle a mortgage payment.
What Steps Should I Take?
So what should you do if you don’t know your debt-to-income ratio, or if you know it’s too high? Or what if you’re getting ready to apply for a major loan, such as a mortgage? Here are some steps to take, starting now:
1. Figure out your DTI.
It’s really not hard to do. Total up all your monthly debt-related obligations. Anything that would appear as a debt on your credit report is fair game. Then, divide that number by your gross monthly income. Are you over 35 percent? Then it’s time to figure out how to get your debt-to-income ratio lower.
2. Pay down some debts.
The best way to fix your debt-to-income ratio is to pay down your debts. Yes, you can also add to your income to fix this ratio. However, if you do this using a side gig, it may not work in your favor when it comes time to apply for your loan. That’s because lenders typically only look at stable income when calculating these numbers. If you work a side gig for a couple of months, that income may not count in your DTI until you’ve filed taxes on your side gig for a couple of years.
3. Keep calculating the number.
Just like you should keep an eye on your net worth, you should also keep an eye on your DTI. In fact, you might consider calculating it every few months, especially if you’re working towards financial freedom.