Debt-to-Income (DTI) ratio measures what proportion of your total income you use for your loan.
Usually, the DTI ratio is used to measure borrowers’ ability to repay the loan. A higher DTI represents that most of your income you spend on borrowing, which is a negative signal for further debts.
Adversely, a lower DTI signals the lenders that you have a sufficient amount of income to support additional debt.
So, the Debt to Income or DTI ratio measures the borrowing risk and tells the lender whether it is safe to lend to someone or not.
Key Takeaways
- DTI measures the borrower’s financial balance between debt and income.
- It signals the lenders about the borrower’s creditworthiness.
- Banks or other lenders use DTI with other factors such as credit score to determine the borrowing limit and interest.
- Lower DTI represents better creditworthiness.
- DTI has limitations, it ignores earning volatility and ignores borrowers’ savings.
How to calculate DTI ratio?
Calculating the Debt to Income (DTI) ratio is easy.
You need to sum up all of your loan payments and divide the amount by your total income. Lastly, convert the figure into a percentage by multiplying 100.
Usually, you need to consider the below items for monthly debt payments:
- Mortgage or rent payment
- Car loan payments
- Student loan payments
- Credit card minimum payments
- Personal loan payments
- Child support or alimony payments
Your total income shall have the following:
- Salary and wages
- Bonuses and commissions
- Income from investments
- Rental income
- Alimony or child support received
Example calculation:
Let’s say your total monthly debt payment is $1,800 and the total monthly income is $5,000. So, your DTI is:
(1800/5000) x 100 or, 36%
Debt-to-Income Ratio Calculator
Use this DTI calculator to quickly assess your creditworthiness.
How to interpret the DTI ratio?
As said earlier, DTI measures the proportion of your income incurred for debt payments. So, you need to understand how lenders interpret your DTI so that you can prepare by settling off any debts before applying for a new loan.
A 20% DTI represents that you have an excellent ability to repay the loan. Borrowers in this range are considered very low-risk and are likely to receive favorable loan terms and low interest rates.
21% to 35% DTI shows a healthy balance between debt and income. Borrowers in this range are generally considered low-risk and can access competitive interest rates.
36% to 49% DTI suggest a moderate debt load. Borrowers may still qualify for loans but might face higher interest rates. For such borrowers, lenders may scrutinize further and re-assess creditworthiness.
50% or higher DTI is considered to be a poor grade. It indicates a high debt load compared to the total income. Borrowers in this range are considered high risk and may have difficulty securing loans. If approved, they are likely to face high interest rates and stricter loan terms.
So, how DTI affect the loan approval & terms?
- Borrowers with lower DTI increase the likelihood of approval.
- A lower DTI ratios typically qualify for lower interest rates, reducing the overall cost of borrowing.
- Maintaining a low to moderate DTI ratio can positively affect the overall credit score of the borrower. It makes future access to loans easy.
According to CNBC, mortgage lenders follow a common rule of 28/36 that represents no more than 28% of gross income should go towards housing expenses, and no more than 36% towards total debt service, including housing.
What are the limitations of the DTI ratio?
DTI is a creditworthiness assessment tool but has some limitations such as the inability to account for all expenses, ignoring income volatility and does not reflect any future earning potential.
A borrower might have a low DTI ratio but must-doable non-debt-related expenses such as medical bills, childcare, or utility costs. These unignorable expenses are not considered in the DTI ratio calculation but can significantly affect a borrower’s financial situation because these payments cannot be ignored like the loan installments.
DTI also ignores income volatility. For example, A freelancer or a seasonal worker with fluctuating monthly income might appear to have a good DTI ratio during high-earning months, but their overall financial stability might be weaker due to the variability in future income. Likewise, DTI does not use any prediction tool to assess the future income stability of the borrower.
DTI calculation also ignores any savings or assets that effectively affect borrowers’ creditworthiness. For example, a person with 45% DTI is considered a high-risk borrower. However, the same person may maintain long-term savings that is a few times higher than the borrowing amount. So, DTI tells about that person’s inability to handle further debt but, his savings or assets act as a supporting financial source of creditworthiness.
Lastly, there is no thumb rule of DTI’s acceptability. Lenders’s opinions and risk exposure also vary from place to place. For example, one lender may refuse a borrower with 45% DTI but the other may accept his loan application. As a result, borrowers can only predict to a certain percentage about their creditworthiness but such variable acceptance range can lead to inconsistencies in how borrowers are assessed across different financial institutions.
How can you lower the DTI?
Lowering your debt-to-income ratio can enhance the chance of faster loan approval with a low interest rate.
Here is some effective strategies to make your DTI ratio low:
- Increase your income by seeking promotion, pay rise, or generate side hustle utilizing your skills and hobbies. It will strengthen your bank statement and overall income.
- Reduce your debt by paying some existing loan liability. You can also try consolidating and refinancing of loan to make the monthly installments smaller.
- Until your DTI gets in the acceptable range, avoid any further debt. Use our financial planning tips for better financial management that effectively increases your DTI.
- Always stick to your budget by tracking your expenses and cutting all unnecessary costs.
- Negotiate with your existing lenders to reduce the interest. It will make your monthly installment smaller which positively affects the DTI ratio.
DTI vs Debt to Limit ratio
DTI and Debt-to-Limit ratio are two essential creditworthiness measurement tools used by the lenders. However, these two metrics are used for different purposes.
A DTI ratio measures the percentage of your total earnings utilized for debt payment purposes and the Debt to Limit ratio measures what percentage of your credit limit you have used that signifies your risk appetite to determine your credit score.
While calculating DTI, lenders use your monthly debt payment and total income. But, in Debt to Limit ratio, lenders use your credit limit and credit consumption to figure out your credit utilization performance.
DTI is mainly used to determine your ability to afford a new debt; however, the Debt to Limit ratio is used for credit performance assessment. Lower utilization rates are better for your credit score as they indicate responsible credit management.
In a nutshell, the purpose of these two ratios is different. DTI is directly used for loan application purposes and the Debt to Limit ratio indirectly influences your loan application by the credit score.
DTI requirements by the different loan types
Different types of personal loans require different DTI ratios to be in an acceptable stage.
Here’s a table that shows different loan types and respective DTI ratio requirements.
| Loan Type | Maximum DTI Ratio | Notes |
|---|---|---|
| Conventional Mortgage | 36% – 45% | Some lenders may allow up to 50% with strong compensating factors. |
| FHA Mortgage | 43% – 50% | FHA loans are more lenient; may go up to 50% with compensating factors. |
| VA Mortgage | 41% | VA loans can exceed 41% DTI if the borrower has strong residual income. |
| USDA Mortgage | 41% | USDA loans typically require a DTI ratio of 41% or less. |
| Personal Loan | 36% – 50% | Lenders prefer lower DTIs but may accept higher ratios for strong credit. |
| Auto Loan | 36% – 50% | Similar to personal loans, varies widely depending on lender and borrower. |
| Home Equity Loan/HELOC | 43% – 50% | Higher DTI ratios may be allowed with good credit and substantial equity. |
Generally, conventional mortgages prefer a DTI ratio of 36% or less but can go up to 45% or higher with strong compensating factors like a high credit score or significant savings. Usually, mortgages are secured in nature which lowers the lenders’ risk exposure.
The FHA loan program accepts higher DTI because it is designed to make homeownership accessible to more people, including first-time homebuyers who may not have a strong credit history or large down payments.
Moreover, FHA loans are insured by the Federal Housing Administration, which reduces the risk for lenders.
In summary, lower DTI will always allow you to enjoy faster loan processing and low interest rates. Borrowers need to prove to the lenders that there is a low risk of default. DTI is just a matrix to explain that story of creditworthiness.
Conclusion
A DTI ratio is a useful tool to assess borrowers’ capacity to afford a new loan. A lower DTI is always better and leads to lower interest rates and flexible loan terms.
We suggest you use our DTI calculator to initially assess your creditworthiness and if needed, follow the strategies on how to lower your Debt to Income ratio.
Good luck!
