The debt-to-income (DTI) ratio is the percentage of your monthly income that goes towards paying down your debt. For instance, if you earn $4,000 a month and your monthly debt payments are $800, then your DTI is 20%. This means that 20% of your income is being used to pay your debt obligations.
When lenders give out loans, they take into account several factors that can affect a borrower' s ability to repay the loan, including DTI.
DTI takes into account following debts and expenses:
- Credit card and loan payments
- Monthly alimony or child support
- Rent or mortgage payments
- Debt repayments from past loans or wage garnishment
However, it does not include expenses like:
- Utility bills or subscriptions
- Health insurance costs
- Variable and entertainment expenses
There are two types of DTI:
- 1. Front-end DTI
The front-end DTI measures the debt-to-income ratio that you' d have in future if the lender approved the loan you are applying for. So, the ratio is based on your future monthly income from all sources and monthly loan payments.
- 2. Back-end DTI
The back-end DTI measures the debt-to-income ratio which is a measure of your total monthly income (from all sources) against all monthly debt payments. So, it takes into account all your debt payments such as mortgage payment, student loan, personal loan, credit card bill, and others.
Although both types of DTI are important, typically, lenders prefer to focus on front-end DTI.
How to Calculate Your Debt-To-Income Ratio
To calculate your debt-to-income ratio, find out how much you owe lenders for each debt that you have taken. Then follow the steps given below to calculate your debt-to-income ratio:
- 1. Add up all your monthly debt payments such as a mortgage, credit cards, wage garnishments, monthly alimony or child support and other types of debt.
- 2. Divide the total debt by your monthly income (before taxes).
The result is a DTI of 35.0%. The lower your DTI, the higher your chances of securing a loan.
How DTI Affects Your Chances of Securing a Personal Loan
Generally, lenders are looking for low debt-to-income ratios because such borrowers are more likely to manage their loan payments effectively. Borrowers who have fewer debt payments, rent or fixed expenses each month have higher financial freedom and typically manage their finances better than those who are overextended. Because lenders want to be sure that they profit from giving out loans, they prefer to give loans to borrowers with lower DTIs.
Lenders prefer a DTI of 36% or lower in most situations. This is because higher DTIs can be risky and lead to problems with repayment. Lenders want to work with clients who properly follow the repayment schedule in future that they agree to.
But some lenders can offer loans to borrowers who have a DTI as high as 43%. This is because some borrowers have a high total income and high debt obligations due to the nature of their business or lifestyle. However, DTI is not the only factor that is taken into account when approving a loan. Factors such as credit score, debt repayment history, and several other factors also affect borrower' s ability to repay a loan.
A DTI ratio alone cannot clearly define a borrower’s ability to repay the loan but it is one of the most important ratios and metrics that lenders calculate and assess. The most important factors are an individual’s credit score and history.
If you want to improve your DTI ratio because you are planning to apply for a loan, there are two things that you can do:
1. Reduce your debt
Pay your student loan quickly or avoid using credit cards. This will lower your total debt and the DTI.
2. Increase your Income
If you cannot lower your debt, try increasing your monthly income by starting a side hustle, or investing in a venture that pays returns (interest) on monthly basis.