What is Debt to Income Ratio?
The Debt to Income Ratio (DTI) measures the creditworthiness of a consumer by comparing their total monthly debt payment obligations to their gross monthly income.
Table of Contents
- How the Debt to Income Ratio Works (DTI)
- How to Calculate Debt to Income Ratio (DTI)
- Debt to Income Ratio Formula (DTI)
- What is a Good Debt to Income Ratio?
- Debt to Income Ratio Calculator (DTI)
- 1. Monthly Debt and Income Calculation Example
- 2. Debt to Income Ratio Calculation Example (DTI)
- Front-End vs. Back-End DTI Ratio: What is the Difference?
How the Debt to Income Ratio Works (DTI)
The debt to income ratio (DTI) is a method to determine the ability of a borrower to satisfy all payment obligations associated with the financing arrangement.
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 are greater (and vice versa).
In practice, the debt to income ratio is most common among lenders to determine the creditworthiness of a potential borrower, i.e. analyze the default risk.
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 | Description |
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Interest Expense (Periodic Payments) |
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Loan Repayment (Principal Amortization) |
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For example, an individual consumer who 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.
The lender must thereby make sure that 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 rates 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.
How to Calculate Debt to Income Ratio (DTI)
The process of calculating a consumer’s debt to income (DTI) ratio can be broken into a four-step process:
- Calculate the Consumer’s Total Debt Payment Obligations Owed per Month
- Calculate the Consumer’s Gross Monthly Income (Unadjusted Pre-Tax Earnings)
- Divide the Consumer’s Monthly Debt Payments by the Gross Monthly Income
- Multiply by 100 to Convert the DTI Ratio into a Percentage
Debt to Income Ratio Formula (DTI)
The debt to income ratio formula compares the value of the anticipated monthly debt obligations to the borrower’s 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 enough.