Explaining Debt-to-Income Ratio

Explaining Debt-to-Income Ratio

If you’re considering applying for a loan, you may have come across the term debt-to-income ratio, often abbreviated as DTI. We’ve compiled information below to help you understand what DTI is and how it’s calculated, as well as what it’s commonly used for.

What is Debt-to-Income Ratio (DTI)?

DTI is a comparison of your required monthly debt payments to your monthly gross (pre-tax) income. Potential lenders often look at this number to help determine whether or not they believe you’ll be able to repay money you’re requesting to borrow from them.

How is Debt-to-Income Ratio (DTI) calculated?

DTI is relatively easy to calculate.

  • First, you add up all of your monthly debt obligations, such as auto or student loans and credit card payments.
  • Next, you determine your gross monthly income. This is the amount that you earn before taxes are taken out of your check, not the amount that you actually bring home each month.
  • Once you have these two numbers, you divide your total monthly debt payments by your monthly gross income.
  • Now multiply this answer by 100 to get a percentage.

Let’s look at an example. For this, let’s assume you have a $250 car payment, a $400 student loan payment, a minimum payment of $100 on your credit cards, and a monthly gross income of $2,500. Following the steps above, you can see that in this scenario, you’d have a DTI of 30%.

  • Total monthly debt payments: $750
  • Monthly gross income: $2500
  • $750/$2500 = .3
  • .3×100= 30%

Explaining Debt to Income Ratio

What Should You Include in Your DTI?

When calculating DTI, you’ll typically only include recurring monthly expenses in your debt total, such as mortgages, auto loans, student loans, minimum payments on credit cards, and legal obligations like child support. You typically won’t include varying expenses like a cell phone or electric bill.

When determining your gross monthly income, it could be as easy as looking at your pay statement if you only have one income source. Depending on your specific situation, however, you may need to do a bit more work. You’ll want to include all sources of income, such as your salary, tips, Social Security, and retirement income.

What is DTI Ratio Commonly Used For?

As mentioned above, DTI is one way that lenders decide if you can afford to take on a new debt. If you have a high DTI, it may signal that you’ve taken on too much debt and may struggle to make your monthly payments. If you have a low DTI, it’s more likely that you’re able to afford the debt you’ve assumed.

One of the most common times DTI comes into play is when you’re applying for a mortgage.

Research shows that mortgage borrowers with a higher DTI are more likely to struggle with making their monthly mortgage payments. Therefore, most lenders set a cap on how high a potential borrower’s DTI can be in order to be approved for a mortgage and to help determine how much that mortgage can be.

When applying for a mortgage, the DTI we’ve discussed here is sometimes referred to as the back-end ratio. In addition to this ratio, mortgage lenders also look at another kind of DTI – your front-end ratio. The front-end ratio is the total of your home-related expenses (i.e. mortgage, property taxes, insurance, HOA fees) divided by your monthly gross income.

What Are the Limitations of DTI?

While DTI is helpful in getting a pulse on your financial health, there are limitations to it. For instance, your DTI doesn’t include monthly expenses that aren’t considered debt, such as phone or electric bills, groceries, etc. Additionally, DTI only considers your income before taxes, not what you actually take home each month.

Because of these limitations, it’s important to not base your own borrowing decisions solely on your DTI. Before taking out additional credit, you’ll want to take a more holistic look at your budget and consider all your expenses.

How to Improve Your DTI

If you’re hoping to apply for a new loan and your DTI is high, there are a few ways you can lower your DTI.

  • Pay down existing debt: Consider using the snowball or avalanche method to focus on eliminating debts.
  • Avoid taking on new debt: Don’t take on new loans, co-sign loans for others, or increase the balance on your credit card.
  • Increase your income: It may not be possible to get a raise in your current job, but you can consider taking on a second job with reliable, steady income.

It’s important to note that lowering your DTI doesn’t directly impact your credit score. Credit reporting bureaus don’t know your income, so they can’t calculate your DTI. However, because the amount you owe accounts for 30% of your credit score, paying off debt can help improve your score.

Refinance High-Interest Debt to Help Lower Your DTI and Save

If you’re ready to lower your DTI, one way to speed up your debt payoff plans is to look for loans with lower interest rates. Whether it’s a Visa® balance transfer or refinancing a home or auto loan, we offer our members competitive rates that can help you save and pay down debt faster. Contact us today to get started.

The content provided in this publication is for informational purposes only. Nothing stated is to be construed as financial or legal advice. Some products not offered by PSECU. PSECU does not endorse any third parties, including, but not limited to, referenced individuals, companies, organizations, products, blogs, or websites. PSECU does not warrant any advice provided by third parties. PSECU does not guarantee the accuracy or completeness of the information provided by third parties. PSECU recommends that you seek the advice of a qualified financial, tax, legal, or other professional if you have questions.