If you’re considering applying for a mortgage or personal loan, you may have seen the term debt-to-income ratio used by your lender. Your debt-to-income ratio is a way that a lender can evaluate your financial habits as it shows how much debt you maintain compared to your income. As a borrower, it’s important to understand what your debt-to-income ratio means, how to calculate it and how to improve it.
What is Debt-to-Income Ratio?
Debt-to-income (DTI) ratio is a measure of your ability to make your loan payments every month. It’s a snapshot that shows how much debt you carry relative to your income on a monthly basis. When you apply for a mortgage or another type of personal loan, most lenders will evaluate your DTI ratio when deciding whether to extend you a loan. A lower DTI ratio is better and will help you get approved more easily for a mortgage or loan.
Since the DTI ratio is expressed as a percentage, it doesn’t matter how much you make. You can have a very high DTI ratio and still make a lot of money each year. The DTI ratio is a good gauge of how you spend money and manage debt each month. Individuals who have a good handle on their finances will typically have a low DTI ratio, regardless of their income.
Front-end Debt-to-Income Ratio: Sometimes a lender may calculate your debt-to-income ratio using just your housing expenses (i.e., mortgage or rent payments and, if applicable, property taxes and homeowners insurance). This is called a front-end DTI ratio.
Back-end Debt-to-Income Ratio: Other times, a lender may calculate your debt-to-income ratio excluding your housing expenses. This is known as a back-end DTI ratio.
How to Calculate Your Debt-to-Income Ratio
Your debt-to-income ratio can be calculated by dividing your monthly debt payments by your gross monthly income. Monthly debt payments include rent or mortgage payments (including your property taxes and homeowners insurance), alimony or child support payments, credit card debt payments, student loan payments, auto loan payments and any other loan or debt payments. In general, though, you don’t want to count any monthly expenses such as groceries, gas, utilities, entertainment or personal taxes in your DTI ratio. Your gross monthly income is the income you make each month before taxes.
Monthly Debt Payments ÷ Gross Monthly Income = Debt-to-Income Ratio
Let’s walk through an example. In this example, your monthly income before taxes is $4,000. You have a mortgage on your house, which is $1,000 per month. You also have an auto loan for $300 a month and a student loan payment of $500 per month. Your total monthly debt payments in this case would be $1,800 ($1,000 + $300 + $500). To calculate your debt-to-income ratio, you would divide $1,800 by $4,000, which is 0.45. Multiply that number by 100 to get 45%.
Using the example above, your back-end DTI ratio, which excludes your mortgage payments, would be 20% ($800 ÷ $4,000). Your front-end DTI ratio, which only includes your mortgage, would be 25% ($1,000 ÷ $4,000).
What is a Good Debt-to-Income Ratio?
The lower your debt-to-income ratio, the better. A lower DTI ratio shows a lender that you are less risky and more likely to pay back your loan each month. In general, a DTI ratio of 35% or less is considered good. This means that the amount of debt you have compared to your income is manageable.
|< 36%||Good: The amount of debt you have compared to your income is very manageable.|
|36% - 49%||Okay: There is room for improvement. The amount of debt you have compared to your income could become unmanageable very easily.|
|≥ 50%||Unacceptable: More than half of your income is going towards debt payments, meaning it’s difficult for you to save money or handle unforeseen expenses. You will have trouble getting approved for a new loan.|
A DTI ratio of 36% to 49% is considered acceptable, but it also means you have some room for improvement. At this level, you could easily find yourself in trouble if a large unforeseen expense occurs, and you may encounter some difficulty in getting approved for a new loan.
When you have a debt-to-income ratio of 50% or more, you will probably encounter a lot of difficulty if you apply for a new loan or mortgage. This is because over half of your gross income is going towards debt payments each month, making it hard for your to save money or handle unexpected expenses. Lenders will view you as a risky borrower who is likely to pay late or miss payments altogether.
If you’re planning on taking out a mortgage, a debt-to-income ratio of 43% is typically the highest a borrower can have and still get a qualified mortgage. If your DTI is higher, you will not qualify for one. If you’re planning on taking out a personal loan, some lenders have debt-to-income ratio requirements. Some lenders, like Prosper, only accept borrowers with DTI ratios below 35% to 45%. Some lenders will calculate your DTI ratio excluding mortgage or rent payments, so they might look for a ratio under 20% to 25%. However, because personal loans are frequently used to consolidate debt, you can still get a personal loan even if you have a higher DTI ratio.
Because your DTI ratio uses your pre-tax income, it can be an aggressive or overly optimistic measure. From our example above, a person making $4,000 per month, or $48,000 per year, would be in the 25% federal income tax bracket (and this doesn’t include state and local income tax). This person would pay roughly $7,738 per year in federal income tax, which would be $644 per month. This means that the person’s monthly take home pay would be closer to $3,355.