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Debt to Income Ratio (DTI)

Guide to Understanding the Debt to Income Ratio (DTI)

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Debt to Income Ratio (DTI)

How to Calculate Debt to Income Ratio (Step-by-Step)

The debt to income ratio (DTI) is a method to determine the ability of a borrower to satisfy all the payment obligations associated with a financial obligation.

If a higher proportion of a consumer’s monthly income must be spent on required debt payments, the likelihood of default and the credit risk to the lender is greater (and vice versa).

In practice, the usage of the debt to income ratio is most common among lenders attempting to determine the creditworthiness of a potential borrower, i.e. their default risk.

In order for a lender to achieve the expected return on a loan issuance (or related financing product), the borrower must reliably complete the required debt payments, namely the interest expense and the repayment of the original loan principal.

Sources of Returns
Interest Expense (Periodic Payments)
  • The interest expense reflects the cost of borrowing and consists of periodic payments owed to the lender, which can occur at intervals such as on a monthly, semi-annual, or annual basis.
  • The timing of interest payments is most often on a semi-annual basis for corporate borrowers, whereas consumers are typically charged interest on a monthly basis (e.g. home mortgages and auto loans).
Loan Repayment (Principal Amortization)
  • The original loan amount must be returned in its entirety by the date of maturity, either incrementally based on a set amortization schedule or in a lump sum (i.e. one-time) payment to clear the outstanding debt balance.
  • For corporate borrowers, the amortization of the debt is often gradual with the remaining balance paid at maturity, while consumer debt tends to have a principal balance of zero by maturity.

For example, an individual consumer that took out a mortgage to finance the purchase of a house must issue monthly payments to the bank lender until the mortgage is entirely paid off.

The receipt of the interest and principal is conditional on the borrower’s income being adequate to fulfill the payment obligations on time per the lending agreement.

Thus, the lender must ensure the borrower can, in fact, manage the debt payments with a reasonable margin of safety.

Of course, external factors such as inflation can impact the real interest rate earned, however, the default risk of the borrower is a critical factor that lenders can use to quantify and mitigate the chance of incurring monetary losses.

The process of calculating a consumer’s debt to income (DTI) ratio can be broken into a four-step process:

  • Step 1 → Calculate the Consumer’s Total Debt Payment Obligations Owed per Month
  • Step 2 → Calculate the Consumer’s Gross Monthly Income (Unadjusted Pre-Tax Earnings)
  • Step 3 → Divide the Consumer’s Monthly Debt Payments by the Gross Monthly Income
  • Step 4 → Multiply by 100 to Convert the DPI Ratio into a Percentage

Front-End vs. Back-End Debt to Income Ratio (DTI)

There are two variation of the DTI ratio that can impact which items should (or should not) be included in the calculation of the debt payments.

  1. Front-End DTI Ratio → The front-end DTI ratio compares the consumer’s gross income to only its housing costs, such as rental expense, mortgage payments, and property insurance payments. Hence, the front-end DTI ratio is often used interchangeably with the term “housing ratio”.
  2. Back-End DTI Ratio → The back-end DTI ratio ignores all housing costs and instead, compares the consumer’s gross income to other debt payments like student loans auto payments, credit card bills, court-mandated child support, alimony, and non-housing insurance payments.

In either case, note that only the fixed, recurring debt payments are counted rather than one-time costs that are not expected to continue.

The monthly expenses incurred day-to-day should also be excluded, such as spending related to purchasing groceries and utility bills (e.g. electricity, gas, and water).

Debt to Income Ratio Formula

The debt to income ratio formula compares the value of the anticipated monthly debt obligations to the borrower’s gross monthly income.

Debt to Income Ratio (DTI) = Total Monthly Debt ÷ Gross Monthly Income

The DTI ratio is expressed as a percentage, so the resulting figure must be multiplied by 100.

If a consumer’s gross monthly income varies substantially month over month, the guidance is to use the income amount most representative of the consumer’s “typical” month, i.e. the normalized earnings generated by the consumer.

Because the lender is given access to the relevant income figures, it is in the consumer’s best interests to be conservative, especially if monthly income is sufficient.

What is a Good Debt to Income Ratio?

Each lender sets its own specific benchmarks for what constitutes a “good” debt to income (DTI) ratio. However, the table below outlines the general guidelines to interpret the DTI ratio.

DTI Ratio Generalized Outcome Description
<36% DTI Manageable
  • Most lenders are likely to perceive the consumer’s gross income to be enough to meet the debt payments and proceed with arranging the financing agreement.
36% to 42% DTI Concerning
  • Lenders tend to start becoming weary near the >36% DTI threshold — but if the borrower is still accepted, the terms attached to the debt are most likely to be unfavorable to the borrower to protect the lender’s downside risk.
43% to 50% DTI Limited Options
  • The pool of potential lenders diminishes drastically here, as most would be unwilling to work with the borrower, regardless of the terms on the debt; i.e. the risk of default is too much to undertake.
>50% DTI Unmanageable
  • Practically all traditional lenders would reject the application and the borrower would be better off pursuing a different route (e.g. seeking consulting on debt relief, renegotiation of terms, or maybe even filing for bankruptcy protection).

Therefore, the sub-36% DTI ratio is where the credit risk is deemed manageable by most lenders.

However, other factors such as the consumer’s credit history, liquid assets on file, and the conditions of the credit market on the present date can all still influence the lender’s final decision.

  • Consumer Credit History
  • Liquid Assets (Collateral)
  • Credit Market Conditions
  • Size of Borrowing (Loan)
  • Length of the Borrowing Term

Generally speaking, lenders view consumers with lower DTI ratios more favorably and as more suitable borrowers, since the risk of default on the loan is lower (and vice versa for consumers with higher DTI ratios).

One caveat to a low DTI ratio, however, is that similar to a credit score, not having one presents a risk to lenders since there is no track record of responsible credit management. In effect, the formal recommendation by the Consumer Financial Protection Bureau (CFPB), under the context of mortgage financing, is to maintain a ratio of around 28% to 35% percent.

Learn More → Debt to Income Calculator (Source: CFPB)

Debt to Income Ratio Calculator — Excel Model Template

We’ll now move on to a modeling exercise, which you can access by filling out the form below.

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Step 1. Total Monthly Debt Calculation Example

Suppose we’re tasked with calculating the debt to income ratio of a prospective borrower in order to help determine the lending decision related to mortgage financing.

Starting off, we’ll calculate the consumer’s fixed debt payments, of which there are four.

  • Mortgage Payment = $2,000
  • Car Loan Payment = $600
  • Student Loan Payment = $400

Thus, the total monthly debt of the consumer amounts to $3,000.

  • Total Monthly Debt = $2,000 + $600 + $400 =$3,000

Step 2. Gross Monthly Income Assumption

With our first input — the total monthly debt — complete, the next step is to calculate the consumer’s gross monthly income.

In our simple example, we’ll assume that our consumer’s gross monthly income is $10,000.

  • Gross Monthly Income = $10,000

Step 3. Mortgage Debt to Income Ratio Calculation Example

Since we have the two necessary inputs to calculate the debt to income ratio (DTI), the final step is to divide our consumer’s total monthly debt by their gross monthly income.

  • Debt to Income Ratio (DTI) = $3,000 ÷ $10,000 = 0.30, or 30%

To reiterate from earlier, a sub-36% DTI ratio is interpreted by most lenders as a strong credit profile and reliable borrower.

If the rest of the diligence conducted by the lender confirms the implied credibility of the borrower and the findings from the debt to income rate (DTI) calculation, our hypothetical borrower is likely to be approved for the mortgage.

Debt to Income Ratio Calculator (DTI)

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