One of the effective tools lenders have at their disposal is the debt to income ratio (DTI). They can use this in combination with a credit report and income to get a good indication of your ability to pay back a loan.
Beyond that, the DTI can be a handy tool for individuals to do a quick health check on their current financial situation. Let’s take a look at DTI and even discuss how to calculate your own. It’s not hard, we promise.
What is Debt to Income Ratio (DTI)?
Debt to income ratio, or DTI, is a comparison between the amount you pay each month in bills and the amount of money you earn for that same month. Even though almost all lenders use this tool, you won’t find it on a credit report.
The reason it is such a useful tool for lenders is that it gives an immediate snapshot of your monthly finances. You could have an impressive monthly income, but by the time you pay your bills, there could be nothing left. This is a bad situation.
You will want to make your DTI as small as possible. In the perfect world, yours and mine both would be 0%. But reality starts creeping in, and the DTI starts to creep up. Nonetheless, you should try to keep this number low to allow for some of the finer things in life.
Front-end DTI versus Back-end DTI
Most lenders look at two different types of DTI, front-end, and Back-end. These vary in only the items considered as debt.
For the Front-end DTI, only your monthly housing costs are considered and calculated. Your housing costs include such things as your mortgage payment, insurance, and the property taxes.
The Back-end DTI looks at all your monthly debts when calculating your DTI. This includes everything you regularly pay in a month that is related to debt, including things like student loans, vehicle loans, and of course credit card debt.
The Ideal DTI
I think we said it before, but the ideal DTI is 0%. This means that you have no monthly debt that you are paying. Of course, you will still have utilities and other monthly bills, but that is not the four letter word debt.
But lenders do sometimes come into the picture, so we should discuss what they like to see for a DTI. When it comes to mortgages, many lenders want to see a backend DTI of 42% or less. There are still others that require a back-end DTI of 35% or less.
Many lenders look only at front-end DTI. For these folks, the front-end DTI should be 27% or less. Again, less is more in this case.
Calculating Your DTI
Despite what you may have heard, there is no magic involved in calculating your back-end DTI. You merely need to add up all of your monthly payments involving debt, divide that by your monthly gross income (note we said gross, before taxes and withholding) and multiply that by 100%. In other words,
(Total Monthly Debt Payments / Gross Monthly Income) * 100%
There, that is all there is to it. That wasn’t painful at all, was it. The front-end DTI is calculated the same way, but you count the monthly debt attributed to housing costs. But let’s do an example, just to be sure everything is understood.
Here is Dan. Dan works hard, and he makes $6000 a month. But Dan also has a lot of bills from debts. Counting his mortgage, car loan, and credit card debt, Dan shells out $3000 every month for his bills (Dan must like debt!) By using our handy formula above, we find that Dan has a DTI of:
(3000 / 6000) * 100% = 50% DTI
Wow, Dan has a pretty bad DTI. His 50% DTI would probably not look so good to most lenders. More importantly, Dan is not getting the benefit he should otherwise from his decent income. Dan probably needs to make some changes.
Fixing Dan’s DTI
Dan probably needs a pointer or two in fixing his DTI. Now, there are two ways to make your DTI improve; You can either decrease your debts(always welcome) or increase your income (again, always welcome.)
In Dan’s case, we are going to convince him to sell his sporty car complete with matching loan payment. Dan had a little equity built up in his car, so he can use the money to pay off some credit cards. In the end, Dan’s monthly debt payments dropped to $2000 (this is theoretical, folks, but not impossible.) Dan’s new DTI is now:
(2000 / 6000) * 100% = 33%
Not bad, Dan. But keep up the good work, we know 25% is just around the corner.
As you can see, your debt to income ratio can quickly give you a snapshot of your monthly financial health. You will want to get this number as low as possible since this gives you more possible ways to enjoy life and build wealth. Don’t do it for the lender, do it for yourself. After all, you know you deserve it.