Debt-to-Income Ratio

Debt-to-income ratio, or DTI, is one of the metrics lenders use to determine a person or organization’s ability to make mortgage payments and repay other debts.

It is calculated by dividing an applicant’s monthly debt payments by their gross monthly income, which is the amount of money earned before taxes and deductions are taken out.

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In essence, the debt-to-income ratio, which is expressed as a percentage, shows the balance between debt and income. A DTI ratio of 20% for example, means that 20% of monthly income is going to pay off debts.

Debt-to-income ratio is calculated to see whether you qualify for a mortgage. Credit: Amol Tyagi/Unsplash

What are lenders looking for with DTIs?

Lenders typically seek low debt-to-income ratios and generally don’t lend money unless the DTI is 36% to 43%, but the lower, the better. Higher ratios outside this range can mean that the potential borrower has too much debt to make paying off an additional loan viable.

There are free online DTI calculators, but even with only a rudimentary knowledge of math, the debt-to-income ratio is easy to determine:

• Simply add up all types of monthly debt payments, including those from credit cards, medical bills, timeshare payments, student loans, car loans or lease payments, child support, alimony, personal loans, mortgages, apartment rents and other recurring debt payments. (Debt-to-income ratios do not include living expenses such as food, entertainment and utilities, or paycheck deductions like health insurance or 401(k) contributions.)
• Divide that total by the amount of monthly gross income, a figure that can be found on paystubs or calculated by dividing the annual total of income by 12.
• Multiply the result, a decimal, by 100 to get the percentage.

What kinds of DTIs are there?

It should be noted that there are two types of debt-to-income ratios: front-end DTI and back-end DTI:

• Front-end DTI is the amount of money spent on home-related expenses—everything from property taxes and monthly mortgage payments to home insurance—divided by the monthly gross income.
• Back-end DTI is all other debts—mainly credit cards and loans—that are paid each month.

Although mortgage lenders look at both, the back-end DTI ratio often carries more weight because it represents the entire amount of debt an applicant is carrying.

The debt-to-income ratio should not be confused with the debt-to-limit ratio. Also referred to as the credit utilization ratio, it indicates the percentage of available credit that a borrower is using. In essence, it measures debt balances and tells lenders whether credit cards are being maxed out to pay off debt.

How can you reduce DTI?

To reduce their debt-to-income ratio, borrowers can either cut recurring debt by paying off credit cards or increase gross monthly income. They also can transfer high-interest credit-card balances to lower-interest ones, a strategy that will reduce monthly payments, and hence the DTI, but not the amount of outstanding debt.

The debt-to-income ratio is only one factor that is considered during mortgage applications. Lenders also look at the borrower’s credit history and credit score or FICO, which is based on credit reports provided by credit bureaus. (The FICO acronym stands for Fair, Isaac and Co., the original name of the California-based data-analytics company that created it in 1958. The company renamed itself FICO in 2009.)

The FICO score evaluates five categories: payment history, amounts of money owed, length of credit history, new credit and credit mix.