Debt-to-Income (DTI) Ratio: What's Good and How To Calculate It

What Is the Debt-to-Income (DTI) Ratio?

The debt-to-income (DTI) ratio is the percentage of your gross monthly income that goes to paying your monthly debt payments and is used by lenders to determine your borrowing risk.

Understanding the Debt-to-Income (DTI) Ratio

A low debt-to-income (DTI) ratio demonstrates a good balance between debt and income. In other words, if your DTI ratio is 15%, that means that 15% of your monthly gross income goes to debt payments each month. Conversely, a high DTI ratio can signal that an individual has too much debt for the amount of income earned each month.

Typically, borrowers with low debt-to-income ratios are likely to manage their monthly debt payments effectively. As a result, banks and financial credit providers want to see low DTI ratios before issuing loans to a potential borrower. The preference for low DTI ratios makes sense since lenders want to be sure a borrower isn't overextended meaning they have too many debt payments relative to their income.

As a general guideline, 43% is the highest DTI ratio a borrower can have and still get qualified for a mortgage. Ideally, lenders prefer a debt-to-income ratio lower than 36%, with no more than 28%-35% of that debt going towards servicing a mortgage payment.

The maximum DTI ratio varies from lender to lender. However, the lower the debt-to-income ratio, the better the chances that the borrower will be approved, or at least considered, for the credit application.

DTI Formula and Calculation

The debt-to-income (DTI) ratio is a personal finance measure that compares an individual’s monthly debt payment to their monthly gross income. Your gross income is your pay before taxes and other deductions are taken out. The debt-to-income ratio is the percentage of your gross monthly income that goes to paying your monthly debt payments.

The DTI ratio is one of the metrics that lenders, including mortgage lenders, use to measure an individual’s ability to manage monthly payments and repay debts.

Debt-to-Income Ratio Limitations

Although important, the DTI ratio is only one financial ratio or metric used in making a credit decision. A borrower's credit history and credit score will also weigh heavily in a decision to extend credit to a borrower. A credit score is a numeric value of your ability to pay back a debt. Several factors impact a score negatively or positively, and they include late payments, delinquencies, number of open credit accounts, balances on credit cards relative to their credit limits, or credit utilization.

The DTI ratio does not distinguish between different types of debt and the cost of servicing that debt. Credit cards carry higher interest rates than student loans, but they're lumped in together in the DTI ratio calculation. If you transferred your balances from your high-interest rate cards to a low-interest credit card, your monthly payments would decrease. As a result, your total monthly debt payments and your DTI ratio would decrease, but your total debt outstanding would remain unchanged.

The debt-to-income ratio is an important ratio to monitor when applying for credit, but it's only one metric used by lenders in making a credit decision.

Debt-to-Income Ratio Example

John is looking to get a loan and is trying to figure out his debt-to-income ratio. John's monthly bills and income are as follows:

• mortgage: $1,000
• car loan: $500
• credit cards: $500
• gross income: $6,000

John's total monthly debt payment is $2,000:

$\$2,000 = \$1,000 + \$500 + \$500$$2,000=$1,000+$500+$500

John's DTI ratio is 0.33:

$0.33 = \$2,000 \div \$6,000$0.33=$2,000÷$6,000

In other words, John has a 33% debt-to-income ratio.

How to Lower a Debt-to-Income Ratio

You can lower your debt-to-income ratio by reducing your monthly recurring debt or increasing your gross monthly income.

Using the above example, if John has the same recurring monthly debt of $2,000 but his gross monthly income increases to $8,000, his DTI ratio calculation will change to $2,000 ÷ $8,000 for a debt-to-income ratio of 0.25 or 25%.

Similarly, if John’s income stays the same at $6,000, but he is able to pay off his car loan, his monthly recurring debt payments would fall to $1,500 since the car payment was $500 per month. John's DTI ratio would be calculated as $1,500 ÷ $6,000 = 0.25 or 25%.

If John is able to both reduce his monthly debt payments to $1,500 and increase his gross monthly income to $8,000, his DTI ratio would be calculated as $1,500 ÷ $8,000, which equals 0.1875 or 18.75%.

The DTI ratio can also be used to measure the percentage of income that goes toward housing costs, which for renters is the monthly rent amount. Lenders look to see if a potential borrower can manage their current debt load while paying their rent on time, given their gross income.

Real-World Example of the DTI Ratio

Wells Fargo Corporation (WFC) is one of the largest lenders in the U.S. The bank provides banking and lending products that include mortgages and credit cards to consumers. Below is an outline of their guidelines of the debt-to-income ratios that they consider creditworthy or need improvement.

• 35% or less is generally viewed as favorable, and your debt is manageable. You likely have money remaining after paying monthly bills.
• 36% to 49% means your DTI ratio is adequate, but you have room for improvement. Lenders might ask for other eligibility requirements.
• 50% or higher DTI ratio means you have limited money to save or spend. As a result, you won't likely have money to handle an unforeseen event and will have limited borrowing options.