Your debt-to-income ratio, or DTI, is an important personal finance measure that compares the amount of money that you earn to the amount of money that you owe to your creditors. For most people, this number comes into play when trying to line up financing to purchase a home, as it is used to determine mortgage affordability.
Once financing has been obtained, few homeowners give the debt-to-income ratio much further thought but perhaps they should, as a change to income or addition of new debt can affect one's ability to service existing debt.Our mortgage calculator is a useful tool tohelp estimate monthly payments. In this article, we will show you how the DTI ratio is used.
Key Takeaways
- A debt-to-income ratio (DTI) compares the amount of total debts and obligations you have to your overall income.
- Lenders look at DTI when deciding whether or not to extend credit to a potential borrower, and at what rates.
- A good DTI is considered to be below 36%, and anything above 43% may preclude you from getting a loan.
Calculating Debt-to-Income Ratio
Calculating your debt-to-income ratio is easy. There are two main ways to compute DTI depending on the particular debts and obligations included in the calculation.
The less-strenuous way to measure this ratio is to compare all housing expenses, which includes your mortgage expense, home insurance, taxes, and any other housing-related expenses. Once you have the total housing expense calculated, divide it by the amount of your gross monthly income. A mortgage calculator can be a good resource to budget for the monthly cost of your payment.
For example, if you earn $2,000 per month and have a mortgage expense of $400, taxes of $200, and insurance expenses of $150, your debt-to-income ratio would be 37.5%.
The more precise measurement is to include the total amount of money that you spend each month servicing debt. This includes all recurring debt, such as mortgages, car loans, child support payments, and credit card payments.
When calculating this ratio, you generally don't count monthly household expenses such as food, entertainment, and utilities.
Don't confuse your debt-to-income ratio with yourdebt-to-limit ratio. Also known as your credit utilization ratio, this percentage compares the sum of a borrower's outstanding credit card balances to their credit card limits (that is, all their total available credit). The DTL ratio indicates to what extent you're maxing out your credit cards, in other words—whereas the DTI ratio calculates your monthly debt payments as compared to your monthly earnings and other income. Since your DTL ratio affects your credit score, mortgage lenders may look at it as well.
Gross vs. Net Income
For lending purposes, the debt-to-income calculation is always based on gross income. Gross income is a before-tax calculation. As we all know, we do get taxed, so we don't get to keep all of our gross income (in most cases). Because you can't spend money that you never receive, the result is a somewhat aggressive picture of your spending ability.
Consider the $2,000 per month gross monthly earnings example. Ata tax rate of 15%, that $2,000 per is reduced to about $1,708 (or less depending on retirement plan contributions and other pre-tax deductions).
Despite the use of gross income in the DTI calculation, you can't actually pay your bills with gross income, and net income (i.e., your take-home pay) will always be less than the number used in the DTI calculation. In our example, that's nearly $300 that was used to help determine your spending ability but that won't actually be there to work with when it comes time to pay your bills.
Don't forget that, if you are in a higher income bracket, the percentage of your net income lost to taxes will be even higher. Regardless of your tax bracket, you'll almost certainly be better served by a more conservative approach to your debt-to-income ratio calculation. For anything other than loan eligibility, consider basing your calculations on net income rather than gross income. Using the net number provides a much more realistic picture of your true ability to spend and take on debt.
Good and Bad Numbers
Your debt-to-income ratio tells you a lot about the state of your financial health. Lower numbers are indicative of a better scenario because less debt is generally viewed as a good thing. After all, if you don't have debts to service, you will have more money for other things. From exotic vacations to saving for retirement, most people can think of a million ways to spend a few extra dollars. Unfortunately, a high debt-to-income ratio often means that there aren't many extra dollars left at the end of the month.
What, then, is a good debt-to-income ratio? Traditional lenders generally prefer a 36% ratio, with no more than 28% of that debt dedicated toward servicing the mortgage on your home. A debt-to-income ratio of 37% to 43% is often viewed as an upper limit, although some specialty lenders will permit ratios in that range or higher. Fannie Mae, in some cases, will back loans extended to borrowers with DTIs of up to 50%, for example, if they meet certain credit score and cash reserve requirements.
Note that if such lenders are willing to give you the loan, that doesn't mean that you should take it. Keep in mind that an increasing number of people are in the 41% to 49% range, a zone where financial trouble is imminent. Nearly all experts agree that a debt-to-income ratio above 50% is living dangerously. For many people, the best ratio is as close to 0% as possible, a number that represents debt-free living. While everyone has bills to pay and most of us have at least some recurring debt, unless your income source is unlimited and guaranteed, a lower debt-to-income ratio is almost always better than a higher ratio.
Want to lower—that is, improve—your debt-to-income ratio? Basically, there are two ways:
- Reduce your monthly recurring debt
- Increase your gross monthly income
Easier said than done, admittedly. Of course, you can also try a combination of the two.
Monitoring your debt-to-income ratio is a great way to keep tabs on your expenses and your buying power. Regardless of whether you earn $25,000 a year, $100,000 a year, or $1 million a year, your debt-to-income ratio provides a snapshot of your spending habits. It's possible to have a small income yet, courtesy of good spending habits, have a low debt-to-income ratio. It's also possible to have a high income but poor spending habits, resulting in a high debt-to-income ratio.
In the end, it's not how much you earn but how much you spend that makes all the difference.
The Bottom Line
Keep in mind that the more you add in debts, either through housing or recurring debts, the higher your ratio will be. The higher your ratio, the more likely you are to be in financial danger. To make sure you're on the path to financial freedom, you can calculate this ratio each quarter to keep your finances moving in the right direction.
If your debt-to-income ratio doesn't paint the picture of economic health that you'd prefer to see, you'll need to take steps to improve the picture. To find out how to move in the right direction, read more about how toget your finances in order and steps to building wealth.
