Your Debt-To-Income ratio, or “DTI” for short, is essentially all of your monthly debt payments divided by your monthly gross income. DTI is typically shown as a percentage that shows lenders how much money you have coming into your household compared to the expenses.
This number helps lenders because it gives them insights into how you are able to manage your monthly payments in order to repay the amount that you will potentially borrow.
When you apply for mortgages, there is often a certain threshold that you need to meet that lets lenders know you are not taking on more debt than you are able to withstand. Mortgage companies prefer borrowers with a low DTI, which means that they are less likely to be at risk of missing payments or defaulting.
How Do You Calculate Your DTI?
Debt-to-income is a ratio shown as a percentage of your debt compared to income. How do we know how to derive this percentage? What is the formula for calculating debt-to-income, how will we know what a good percentage is, and what exactly is your DTI?
How To Calculate Debt-To-Income Ratio
To calculate your debt-to-income ratio, you simply add up your monthly debts and compare them to your income. It is really that simple of a calculation:
DTI = Monthly Debt Payments/Gross Monthly Income
Your gross monthly income is based upon if you are an hourly or salaried worker. If hourly, your gross monthly income equals your hourly pay multiplied by the hours you work a week and the amount of weeks you work a year, then divided by the 12 months of the year. If you are a salaried worker, you just take your annual salary and divide it by the 12 months of the year.
For a simple example, if you make $60,000 per year, your gross monthly income would be $5,000. Taking this to be your monthly gross income, if you estimate your monthly debt payments to be $2,000 – your DTI would be as follows:
DTI = $2,000/$5,000 = 40%
What Is My Debt-To-Income Ratio?
You may be thinking to yourself, what is my debt-to-income ratio? How can I figure out what my monthly expenses are in order to derive this calculation? Let’s review a real-life example using typical monthly expenses that someone would have.
Let’s say you have an annual salary as mentioned in the previous section, $60,000; your total gross monthly income is $5,000. To determine your monthly debt payments we must itemize everything that would be included in your credit report. With our real-world example, we have the following breakdown resulting in total monthly expenses = $1,800.
- Mortgage/Rent: $800
- Auto loan: $400
- Student loans: $300
- Credit cards: $100
- Miscellaneous debt on your credit report: $200
DTI = $1,800/$5,000 = 36%
What Is A Good Debt-To-Income Ratio?
Is the 36% that was calculated above a good debt-to-income ratio? If not, what is considered a good percentage? It turns out that 36% is an adequate range for your debt-to-income ratio if you are a homeowner. The typical rule of thumb for DTI is:
- Up to 35%: Ideal range
- Your bills are well managed and you will most likely have money left over after paying monthly expenses
- 36% to 49%: Acceptable range
- You could improve in some areas to reduce your monthly debts
- 50% and over: Not an ideal range
- You most likely will not be able to cover any emergency situations, nor have spare money after paying monthly expenses
What Does DTI Tell Lenders?
Your debt-to-income ratio tells a prospective lender how well you are at managing your debts compared to your income. If you have either a low or a high DTI, this could tell lenders different things about your financial situation.
Low Debt-To-Income Ratio
A low debt-to-income ratio shows that someone has a good balance between debt and income. Someone with a low DTI can manage their monthly debt payments effectively, and probably will have excess money after paying off debts.
High Debt-To-Income Ratio
Someone with a high debt-to-income ratio shows a poor balance of debt and income, basically the opposite of someone with a low DTI. Monthly debt payments may be a struggle to manage with a high DTI. Excess money may not be available in case of emergencies as well.
Limitations Of DTI
Debt-to-income ratio is only one factor or metric used in a credit making decision. It is important to monitor, but it’s only one part of a lender’s decision-making process. Other things such as credit score and credit history also weigh in heavily on the lender’s decision to extend credit to the borrower.
The DTI also does not differentiate between types of debt and the costs associated with servicing those debts. An example would be credit cards having a higher interest rate than other types of debts, for example, a car loan.
Both of these would still be calculated in the DTI ratio though. Credit cards can be transferred from a high-interest rate to a lower interest rate, which would make the payments lower, as well as your DTI, but the overall debt amount would remain the same.
Mortgages and DTI
Studies of mortgage loans show evidence that people with higher DTI are more likely to have issues with making their monthly mortgage payments. Mortgage lenders review your DTI for both your total debt, as well as your mortgage debt when considering your loan application. A common guideline is to maintain a 28% to 35% mortgage debt-to-income ratio.
How To Lower Your DTI
There are two main ways to lower your DTI. You can either increase your income or lower your recurring debt. Using the previous example where you make $60,000 and have $1,800 monthly debt payments. The DTI was 36% with that example, let’s look at how raising your income, or lowering recurring debt can help lower your DTI.
Raising Your Income
One way to raise your income is to get a higher paying job. Another may be to find side jobs or supplemental income. If you were to go out and get a different job that increases your income to let’s say $72,000, this would mean your gross monthly income would be $6,000 now. Your new DTI would then be:
DTI = $1,800/$6,000 = 30%
Lowering Your Monthly Debt Payments
If you are unable to get additional income, one thing you can always look at is reducing your debts. If you have an opportunity to pay off the remaining amounts on your student loan, car loan, or miscellaneous items that show up on your credit score, this will lower your monthly debt payments. For this example, if we say that you were able to pay off your auto loan and get rid of the $400 payment, this would reduce your expenses to $1,400. Your new DTI would then be:
DTI = $1,400/$5,000 = 28%
Debt-To-Income Ratio: The Bottom Line
Your debt-to-income ratio is an indication of how well you handle your expenses or debts with your annual income. This is determined by a simple formula that provides you with a percentage that is an important factor when trying to get a mortgage. Luckily, it is not the only factor that is considered when going through the mortgage application process.
Also, there are things you can do to reduce your DTI if you are not comfortable with your number.
This page last updated: March 29, 2022