One of the personal-finance metrics to help you with your debts is the debt-to-income ratio (DTI). It compares your total debt to your gross income.
To get your debt-to-income ratio, you must divide your total recurring monthly debt by your gross monthly income. There is a reason why you need this specific number.
According to Firstrepublic, the average American debt-to-income ratio for 2021— comparing overall debt to annual income was 145%.
So why is this metric important? Because debt lenders use this metric to understand your capabilities to repay the money you own or make sure you can pay the additional debt should you want to take it as a mortgage?
It’s also a useful statistic to know personally for your finances when you need to decide on whether you should make that big purchase or not.
This article will seek to discover how to calculate your debt-to-income ratio and learn more about it.
- If you have a plan to make a massive purchase financially, then you should include that while calculating your debt-to-income ratio.
- Debt-to-income ratio is actually a vital ratio that every household must know about.
- Not knowing how much debt you owe as compared to your income can lead you to bankruptcy.
What is Debt-to-Income Ratio?
A Debt-to-Income or DTI is obtained by dividing your monthly debt payments and gross income. The ratio then obtained is expressed in percentage terms.
Lenders use this ratio to determine how smoothly you will be able to manage monthly payments towards your loan and if you can even afford to have one.
Generally, consumers with high DTI are considered risky borrowers by lenders. This is because consumers with high DTI run the risk of not being able to repay loans during financial hardship. 1
How do you Calculate Debt-to-Income?
Here’s a step-by-step guide how how to calculate debt-to-income ratio:
- The first thing that you need to do to start the process is to add up all of your regular monthly bills to get your debt-to-income ratio. Aside from your mortgage, additional recurrent obligations may include any loans, such as student or vehicle loans, credit card payments, or other debt that you have to pay every month.
- Following this, you must estimate your gross income before taxes. This includes your salary, tips, pension, child support, or any other form of income that comes into your bank account.
- After learning about these numbers, then you need to divide your entire monthly recurring debt by your pre-tax gross monthly income.
- The number you get will be a decimal, which then you have to multiply by 100 in order to get the percentage of your debt-to-income ratio. 2
How to Check If You Can Afford Your House Using Your DTI Ratio?
Factors That Make Up the DTI Ratio
There are two components that mortgage lenders use for the DTI ratio. Let’s have a look at them:
- Front-end ratio: This ratio is also called a housing ratio, and it suggests the percentage of monthly income that goes for your housing expenses. This includes your homeowners insurance, monthly mortgage payment, property taxes, etc.
- Back-end ratio: This ratio shows your income portion that is needed to cover monthly debts, along with housing expenses and mortgage payments. This includes student loans, credit card bills, child support, car loans, etc.
What Should Your Debt-to-Income Ratio Look Like?
Ideally, a front-end ratio of no more than 28% and the back-end ratio taking into account all your expenses should not be more than 36%.
However, depending on your savings, assets, expenses, down payment, along with the type of loan, etc., lenders may agree to accept a higher DTI ratio.
How does it Help your Finances?
If you have a plan to make a massive purchase financially, you should include that new purchase in your calculations while calculating your debt-to-income ratio because any lender who is taking a look at your application will also consider it.
You have the freedom to use a calculator online to determine the payment you need to make for your monthly mortgage payment or a new car financing loan.
By comparing your finances’ before and after ratios, you can easily assess if you can afford that new home or automobile right now.
That is how the debt-to-income ratio helps you and your finances.
Practical Tips to Reduce Your Debt-to-Income Ratio
Here are effective ways that can help you in reducing your debt-to-income ratio:
- Create a budget by tracking down and cutting down on all your unnecessary expenses, and start putting more money towards your various debts.
- Do not use a credit card for any major purchases or new loans. This is especially important to remember during and before a home purchase. Taking up a new loan will increase your DTI ratio and will also hit your credit score. In the same manner, too many credit inquiries will have a similar impact.
- Start repaying your debts: If you have too many unpaid debts, then start paying them as soon as possible. There are different methods, such as the snowball or avalanche method, that you can use to make payments towards your debt in an effective manner. 3
Debt-to-income ratio is actually a vital ratio that every household must know about because nowadays, everyone has some debt one way or another, and not knowing much debt you have compared to your income is dangerously risky as it might put you in bankruptcy with some wrong extra debts that you take on.
That is why you need to always calculate your debt-to-income ratio before making a decision about a purchase, whether big or small.
You can easily calculate this ratio without any external help; all you need to know is all of your debts and gross income before tax.
Once you know these, you can calculate them in seconds.
Does My DTI Ratio Impact My Credit?
While scoring your credit, Credit bureaus don’t consider your income so DTI does not have any significant bearing on yout credit score.
However, borrowers those who have a high DTI ratio also have a higher credit utilization ratio. And this accounts of 30% of your credit score. 4
What does debt-to-income ratio include?
Debt-to-income ratio includes your gross income and all your monthly expenses such as insurance premiums, rent, auto loan repayment, mortgage, student loan, etc.
What is not included in a debt-to-income ratio?
Recurring monthly bills should not be included while calculating DTI. This is because recurring monthly bills show fees for services and not for debt.
Some examples of recurring monthly bills include electricity bills, gas bills, utilities, etc.
Traci is a highly experienced debt resolution expert with over 8 years of expertise in helping people become debt-free through various debt relief programs. As a former employee of a well-known debt relief company, she possesses exceptional knowledge and skills to take care of debt-related issues.
When not writing about debt, Traci can be found conducting in-depth research on the latest developments in the industry to ensure that she stays up-to-date with the latest trends and strategies.
The National Planning Cycles is committed to producing high-quality content that follows industry standards. We do this by using primary sources, such as white papers and government data alongside original reporting from reputable publishers that were appropriate for the accuracy of information while still being unbiased. We have an editorial policy that includes verifiable facts with due credit given where applicable.