Calculating Debt-to-Income Ratio
The debt to income (DTI) ratio is a calculation that helps you determine what portion of your monthly gross income is utilized for debt payments. The gross income here is the entire sum you have before the taxes and other deductions are calculated.
The debt to income ratio is an important number for lenders to identify whether you can cover your monthly expenses besides managing debts. It also gives you a good indication of your financial circumstances before you make any important decision related to your finances.
When you want to apply for different types of installment loans like a personal loan or mortgage, you must have a good debt to income ratio. Along with a good credit score, a good DTI ratio will play an important role in receiving credit approval along with a more attractive APR and better loan terms.
Calculate debt to income ratio with three simple steps:
- Add all your monthly debt payments like mortgages, loans, credit cards, and other debts.
- The total monthly debt payment should then be divided by your monthly gross income.
- Multiply the result by 100 to get the DTI percentage.
Let us consider some examples using the help of debt to income calculator formula.
Assume a monthly gross income is $4,000 along with a home loan of $600 and an auto loan of $400. The expense towards monthly debt payments becomes $1,000.
The ratio be calculated with the help of a DTI calculator in the following manner.
$1,000 (debt payment) / $4,000 (gross income) *100 = 25% (DTI ratio).
If monthly gross payment remains the same, and a lender wants the ratio to remain below 43% to approve new debt, what is the maximum amount that can be borrowed? You can calculate it by multiplying the target debt to income ratio by your monthly gross income.
$4,000 (gross income) x 43% (DTI ratio) = $1,720 or less amount for monthly debt payments.
However, What happens if monthly gross income falls to $3,000 from $4,000?
In this situation, the DTI ratio would be calculated as follows:
$1,000 (debt payment) / $3,000 (gross income) * 100 = 33% DTI ratio.
This implies an increased ratio, which is not ideal. A lower DTI ratio is almost always considered better when applying for a loan.
What Is The Perfect Ratio?
When banks and lenders calculate your DTI before approving your loan, they want to ensure if you can cover your existing debt payments in addition to the new financial burden.
While a specific number may vary between different banks and lenders, you can expect it to be somewhere between 36% to 55%. They make use of the different variations of ratio like front-end and back-end ratios.
The front-end ratio only accounts for housing expenses like property taxes, mortgage payments, and insurance payments. A ratio of 28% to 31% is considered ideal here.
The back-end ratio includes all debt-related payments like credit card payments, auto loans, and other loan balances. Your DTI ratio must generally be less than 43% to be considered eligible for a loan.
There could be exceptions, but regulations of federal agencies do require lenders to prove your ability to repay the debts. Accordingly, DTI is a very relevant credit approval factor.
Debt-to-Income vs. Debt-to-Limit
Unlike the debt to income ratio, the debt-to-limit ratio measures credit utilization. It is a percentage of the borrower’s total credit that is presently utilized. Banks and lenders often use this measure to understand how much available credit from revolving debt a borrower is currently using.
By comparison, the debt-to-income ratio calculates your monthly debt payments against your monthly gross income. Although both ratios are important, you must keep in mind that they are few among many other factors that help in making a credit decision.
When banks and lenders decide to lend money, they also consider other factors like your credit score and credit history.
How To Improve Your DTI
When applying for a loan, ensure that your DTI ratio is low. In case it is on the higher side, you can use these tips to reduce that number.
- Increase Income - It is one of the best ways to prepare yourself before you apply for a loan. Depending on your expertise, try to identify some temporary income-generating opportunities that can help elevate overall income.
- Clear Existing Debts - When you have lesser and smaller monthly debt payments, your DTI ratio will automatically improve. If you have credit card debts, try getting rid of that first.
- Make A Higher Down Payment - You can keep your monthly debt payments lower by giving a large down payment.
- Avoid Other Debts - If you are looking to apply for important loans like a mortgage, refrain from accumulating other debts, especially revolving debt.
Ultimately, you are the best judge to determine what you can afford but recognize that you do need not always borrow the maximum available amount.
Keep in mind various factors, including emergency funds, so that the new debts do not add unnecessary strain to your budget. Repaying existing debts on time will also go a long way in helping you maintain a good credit score and solid credit history.
Of course, when in doubt, a debt to income ratio calculator can be of great help to understand what can be done to improve the likelihood of approval for additional credit.