What is debt-to-income ratio?

Your debt-to-income (DTI) ratio is extremely important to know. Your DTI ratio reveals aspects of financial health that you may not be aware of currently.

 

Lenders often use this ratio to evaluate your eligibility for loans, but what exactly is a DTI ratio and how does it affect other areas of your finances? To fully understand your financial situation, you should be familiar with the basics of DTI ratios and how you can utilize your ratio to improve your economic status. From calculating your DTI ratio to unpacking what your ratio means, the following sections explain essential information to help you optimize your DTI ratio.

 

What Your Debt-to-Income Ratio Means

A DTI ratio compares how much money you owe per month to your gross monthly income. Generally, DTI scores are presented as percentages and reflect your overall financial well-being. Therefore, the ratios are commonly used to assess your ability to pay off debts for things like student loans or credit cards.

Two main types of DTI ratios exist, and each type focuses on a different type of debt. Front-end DTIs, for example, require you to provide your housing costs such as mortgage payments, property taxes and homeowner’s insurance. The front-end ratio then calculates how much of your total gross income is used to pay for those housing costs. This type of DTI ratio is typically reserved for potential homebuyers or homeowners interested in taking home equity, but any resident can benefit from gauging how much money they are spending on housing expenses

The second type of DTI ratio is the back-end. This ratio is a more comprehensive look at your financial status and encompasses all monthly debts including but not limited to housing, credit cards, auto loans and student loans. The purpose of back-end DTI ratios is to compare the amount of debt you may have to your income.

Lower DTI ratios imply that you are financial accountable while higher DTI ratios may suggest that you need to better manage your debt and housing payments. As a rule, you are advised to keep your DTI ratio at or below 36 percent to ensure that you qualify for loans and mortgages, but ratios of up to 43 percent may still qualify. According to Wells Fargo, standard DTI levels and their meanings are as follows:

  • 35 percent or lower: Your debt is manageable and allows you to save, spend and invest as desired.
  • 36 to 49 percent: Your debt may be interfering with your day-to-day expenses and will not be flexible enough to handle unexpected costs. You may choose to borrow money, but you must pay close attention to eligibility criteria.
  • More than 50 percent: This DTI ratio means that more than half of your income is spent on debt payments. This is considered unhealthy and greatly restricts your financial freedom.

Depending on your DTI ratio, you may be encouraged to take immediate action to reduce your debt or to maintain your current spending habits. You are reminded that your DTI ratio is only meant to be used for educational purposes, though, and does not wholly represent your financial status. Each DTI ratio is an estimation and is subject to errors.

How to Calculate Your Debt-To-Income Ratio

To calculate your DTI ratio, you may follow a few simple steps. The steps for determining your ratio are outlined below:

  1. Add all your monthly bills except those for groceries, entertainment, utilities, gas and taxes.
  2. Find your total gross monthly income (i.e., before taxes).
  3. Divide your total monthly bills by your gross monthly income.
  4. Convert the result to a percentage by multiplying the decimal by 100.

The resulting percentage is your DTI ratio. Some DTI calculators may enable you to itemize your monthly bills to facilitate the calculation which may include monthly rent or house payments, alimony, child support, loan payments and credit card payments. However, the following payments should not be included in DTI ratio calculations:

  • Monthly utilities (e.g., electricity)
  • Car insurance
  • Cable
  • Cell phone
  • Health insurance
  • Food or entertainment

Additionally, you must input all sources of your income counting your tips and bonuses, pension, Social Security, child support and alimony when calculating your DTI ratio. You may only enter in the minimum monthly payment required for credit card debts. If you are unsure whether you should include an item in your DTI ratio estimation, you may ask the lender requesting the ratio (if applicable).

 

Why Your Debt-to-Income Ratio is Important

Your DTI ratio serves various purposes and is an invaluable source of financial information. While your DTI is usually requested by lenders to assess your ability to manage loan payments, you may estimate your DTI ratio independently to determine whether you are likely to qualify for loans or not. However, you must remember that your DTI is not the only factor lenders review; your credit history also plays a big role. Still, your DTI is influenced by your credit history.

Not only do lenders utilize your DTI ratios to measure your eligibility for loans and mortgages, but your ratio can help you determine how well you are managing your debt. Consequently, you can discover how comfortable you are with your debt by checking your DTI ratio. If your DTI exposes excessive debt that you cannot necessarily afford, you may want to consult professional financial advisors for advice. Conversely, if your ratio reveals that you have very little debt, you may decide to begin saving or investing your money.

Based on your DTI ratio, you can learn where your money is going and what aspects of your financial health you may need to address. For example, professional recommendations state that you should be spending approximately 30 percent or less of your gross monthly income on housing to ensure that you can afford other essentials, and your front-end DTI ratio can help you identify how much money you are spending on housing. If you are unsatisfied with the amount of money you have left after paying off your debts and other expenses, then a careful evaluation of your DTI ratio may benefit you.

 

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