October 03, 2022 | home-buying
What is the DTI Ratio?
If you’ve ever taken out a loan, you might be familiar with your debt-to-income ratio.
This number— commonly referred to as DTI— is one of the key items a lender reviews when underwriting a loan request, whether it be a personal loan, car loan, home mortgage, or anything in between. Because this ratio plays a big role in determining whether or not your loan is approved, it's important to understand how lenders calculate this number.
In this article, we’ll break down what this number is, how to calculate it, and how to get it in shape if you plan to take out a loan soon.
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What is a DTI ratio and why does it matter?
DTI is a percentage that indicates to a lender how much of your total income is obligated to the debts on your credit report.
In other words, your DTI tells a lender whether or not you can afford the loan. If you have too much debt compared to your monthly income, a lender will see you as a risky borrower— which means you may not get approved for the loan you want.
Front-end Ratio vs. Back-end Ratio
If you’re purchasing a house, you may also hear about front-end and back-end ratios. These are types of debt-to-income ratios that have one key difference: what is included as “debt”.
Front-end ratio: The front-end ratio, also known as the mortgage-to-income ratio, compares housing costs to your monthly income. It indicates how much of an individual’s income goes towards mortgage payments each month. Other associated costs, such as homeowners association dues and property taxes, are included in these housing costs. Other debts, like credit card bills or student loans, are not included in the front-end ratio.
Back-end ratio: The back-end ratio indicates how much of an individual’s income goes towards paying all debts each month. Total debts include your mortgage payment (including taxes, insurance, and interest) and any other debt, such as auto loan payments, student loan payments, credit card payments, and child support.
Note: If front-end or back-end is not specified, the term DTI typically refers to the back-end ratio.
How to Calculate DTI Ratio
In short, DTI is calculated by dividing your total monthly debt payments by your monthly gross income.
Debts you should include:
- Housing payments
- Car payments
- Student loans
- Alimony that you pay
- Child support that you pay
- Credit card monthly payments
- Line-of-credit minimum payments
The calculation does not typically include utility bills, insurance payments, and day-to-day expenses like gas and groceries.
Income you should include:
- Salary and wages, before taxes
- Income you earn from rental properties
- Any other taxable or non-taxable income you wish to be included such as child support or alimony that you receive
After you add up your debts and income, simply plug them into the following formula:
(Debts ÷ Income) x 100 = DTI
DTI Calculation Example
Here’s a real-world example to help you better understand calculating DTI.
Ernie is hoping to purchase a new car and wants to determine his DTI.
He earns $4,500 a month before taxes. He is currently paying $350 a month on his student loan, $225 on his auto loan, and is paying off a credit card bill at a rate of $100 per month. He also has a $1,500 mortgage payment each month.
- Total income: $4,500
- Total debts: $2,175
- (Debts ÷ Income) x 100 = DTI
- ($2, 175 ÷ $4,500) x 100 = 48%
In other words, 48% of Ernie’s monthly income goes towards paying off his debt.
What’s a good DTI ratio?
So you’ve calculated your DTI, but is it a good number? Will you be approved for a loan?
Like many things in finance, it depends. The biggest factor is what type of loan you are applying for and where.
Typically, mortgage lenders like to see a back-end debt-to-income ratio of no more than 36% when approving home loans. Your front-end ratio should be less than 28%. Auto lenders, on the other hand, may approve a loan for a borrower with a DTI between 45% and 50%.
If you have any questions about DTI caps, contact your lender.
Preparing Your DTI Ratio for a Loan
If you plan on taking out a loan in the future— such as a home mortgage— you may be worried that your DTI isn’t quite up to par. The good news is that there are ways to get the number where it needs to be.
There are two ways to lower your DTI ratio: increase your income or decrease your debt. Of course, increasing your income is easier said than done! Typically, people focus on decreasing their debt instead.
If you’re looking to decrease your debt, keep the following tips in mind.
- Pay more than the minimum each month, if possible
- Don’t rack up more debt
- Use a budget to keep track of spending
It also helps to evaluate your debts and develop a plan to tackle them. There are several strategies to consider, including:
- The avalanche method: With the avalanche method, you’ll start by paying off your highest-interest debts. Starting with this one debt will help you focus your efforts on a specific goal and save you money by eliminating your biggest interest charges first.
- The snowball method: With this method, you’ll start by focusing your repayment efforts on the smallest balance, regardless of interest rate. Once that card is paid off, you’ll move on to the next smallest. This is a great option if you’re motivated by small accomplishments.
- Debt consolidation: Rolling multiple debts into one loan can not only make it easier for you to keep track of your debts, but it can also save you money by lowering the amount of interest you pay.
With planning and determination, it is possible to get your DTI into a favorable range before you apply for a loan.
The Bottom Line for DTI
Your DTI ratio is an important factor in determining whether or not your loan gets approved. Like your credit score, it’s important to see where you fall before you apply for a loan. If you determine that your DTI ratio would be a little high for a lender’s liking, work to pay down debt before you send in your loan application.
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