A sound understanding of how to calculate debt-to-income ratio is critical to your overall financial health. Rather than guess and hope for the best, this blog post breaks down everything you need to know about the debt-to-income ratio.
What is a Debt-to-Income Ratio?
Debt-to-income ratio (DTI) is a financial metric that shows how well you manage debt repayment in relation to your total income.
In short, it’s the percentage of your gross monthly income that goes towards paying your monthly debts. Lenders use this to gauge your creditworthiness and risk level, influencing whether you get approved for loans and the interest rates you’re offered.
A lower DTI signifies stronger financial stability, which means you’re not overburdened with debt. Conversely, a high DTI may suggest financial stress and make securing loans or desirable interest rates challenging.
What is the DTI Formula?
The debt-to-income ratio formula is straightforward: divide your total monthly debt payments by your gross monthly income. From there, multiply the number by 100 to convert it into a percentage.
Take, for example, a consumer with $3,000 in monthly debt payments and $6,000 in monthly gross income. Here’s the debt ratio formula you can use:
- $3,000 / $6,000 = 0.5
- 0.5 X 100 = 50%.
- DTI = 50%
With this simple formula, calculating your DTI is something you can do at any time.
How to Calculate Debt-to-Income Ratio
A few steps are involved in understanding how to calculate your debt-to-income ratio.
First, add up your monthly debt payments. This includes mortgage or rent payments, car loans, student loans, credit card debt, and other recurring debts.
Next, determine your gross monthly income. This is your income before taxes or other deductions.
Finally, as noted above, divide your total monthly debt by your gross monthly income, then multiply the result by 100 to get your DTI as a percentage.
Tip: as you calculate your debt-to-income ratio, be sure that you’re using up-to-date and accurate numbers.
How Does DTI Affect My Ability to Get a Loan?
When comparing DTIs, lower is always better. A lower number increases the likelihood of loan approval at the lowest possible rate.
Understanding how to invest in real estate often begins with grasping the importance of financial metrics like your DTI because the lower your DTI, the greater the chance you can comfortably manage your monthly debt load on the income you earn.
Generally speaking, a DTI of 36% or lower is viewed as favorable. On the other hand, a high DTI, typically defined as above 43%, suggests you’re carrying substantial debt relative to your income. This could raise red flags for mortgage lenders, making them more hesitant to approve your loan. In turn, you can be looking at more creative financing for investing in real estate.
What is a Good Debt-to-Income Ratio?
The word “good” in the debt-to-income ratio varies from lender to lender. Generally speaking, a good DTI is anything below 36%. A number in this range shows you have a manageable balance between debt and income.
Taking this one step further, most lenders closely examine the expenses within your DTI percentage (front-end and back-end DTI). For example, if you have a DTI of 36%, they may work off the assumption that no more than 28% of your gross monthly income should go toward housing expenses. The remaining 8% should cover other types of debt, such as car payments, credit card payments, personal loans, and student loans.
It’s important to note that while a lower DTI improves the odds of securing a loan at a competitive rate, it’s only one factor that lenders consider. They also look at your credit score, credit history, credit report, credit utilization ratio, employment history, and bank account balances.
What is front-end debt-to-income ratio?
The front-end debt-to-income ratio is a subset of your total DTI. It represents the proportion of your gross monthly income that goes towards monthly housing costs like mortgage payments, property taxes, homeowners insurance, and any applicable homeowners association dues. A lower front-end DTI generally indicates better financial balance.
What is back-end debt-to-income ratio?
The back-end debt-to-income ratio is a broader measure of your financial commitments. In addition to housing expenses, it includes all recurring monthly debt obligations like auto loans, student loans, credit cards, and child support. All loan payments are factored in. Depending on the type of loan, debts are likely to be paid off at some point, which will improve your ratio.
Your total debt obligations are a percentage of your gross monthly income. A lower back-end DTI is typically more favorable in the eyes of a lender.
Now that you know how to calculate your debt-to-income ratio, you can track your overall financial health more accurately and consistently.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
