The debt to income (DTI) ratio measures the percentage of your monthly debt payments to your monthly gross income. For example, if your monthly debt payments are $3,000 and your monthly gross income is $10,000, your DTI ratio is 30%. Lenders check this during the application process and typically require a DTI of 43-50% or lower.
How to Calculate the Debt to Income Ratio
Your debt to income (DTI) ratio is calculated by dividing your total monthly recurring debt payments by your gross monthly income.
Below is the formula for calculating the debt to income (DTI) ratio:
Debt to Income Ratio = (Total Monthly Recurring Debt Payments) / (Total Gross Monthly Income)
Total Monthly Recurring Debt Payments
Total monthly recurring debts represent all your monthly recurring payments for debt obligations like loans. They typically include all regular payments you cannot cancel, such as mortgage payments, car payments, student loan payments, minimum credit card payments, personal loan payments, real estate taxes, and homeowner’s insurance.
Certain bills such as monthly subscription plans are typically not considered recurring debt because you have the option to terminate these expenses. Also, variable regular expenses like groceries, utilities, and gas are generally not included in monthly recurring debts.
Total Gross Monthly Income
Gross monthly income represents your total monthly income before taxes are deducted. This can include all your income sources such as salary, commissions, and business revenue. However, lenders will typically only consider non-W2 (non-paycheck) earnings like 1099 income if you can show two years of earnings on your prior two tax returns.
For example, if you’re a W2 employee who earns a bi-monthly paycheck with gross earnings of $5,000, your gross monthly income would be calculated as $5,000 times two, or $10k. If you also work with clients on the side and recorded on your tax returns $5,000 in year one and $10,000 in year two, lenders will take the lower amount of $5,000 and divide by 12, adding $416.67 to your total gross monthly income.
Example Debt to Income Ratio Calculation
Let’s take a look at the following for a better understanding of how to calculate your debt to income ratio. Let’s say that you have gross monthly income of $10,000 and an existing monthly debt payment of $1,000. Based on the given information, your current debt to income ratio is calculated as follows:
($1,000) / $10,000 = 10% DTI
Now, let’s say you are applying for a $100,000 loan with a new lender, and your monthly amortized payment for this new loan is expected to be $2,000. When assessing your application, this new lender will include the expected $2,000 debt payment to your existing $1,000 debt payment when calculating your new debt to income ratio:
($1,000) + ($2,000) / $10,000 = 30% DTI
Based on the above example, should you be approved for the new $100,000 loan with monthly payments of $2,000. In fact, a lender might automatically pre-approve you for a loan amount equal to a $4,000 monthly payment, which would equal a 50% DTI ratio.
Why is the Debt to Income Ratio Important?
The debt to income (DTI) ratio is important because lenders use it to assess your ability to cover loan payments and other debt obligations. Lenders will typically only lend up to 43-50% of your monthly gross income, meaning that your combined monthly loan payments cannot exceed a max 50% DTI ratio.
However, it’s not uncommon to follow the 28/36 rule. This rule states that a person or family should spend no more than 28% of its gross monthly income on total household expenses and no more than 36% on total debt payments, leaving at least 36% for things like taxes, discretionary spending, and savings.
The DTI ratio is similar to the debt service coverage ratio (DSCR). Both are used by lenders to assess the ability of a person or entity to take on debt. However, the debt to income ratio is for consumers while the DSCR is used by businesses.
Benefits of a Low Debt to Income Ratio
A low debt to income (DTI) ratio is ideal if you want to get approved for a loan and/or keep your finances stable. Here are few benefits of having a low debt to income ratio:
- You have a better chance of getting approved for higher loan amounts with higher monthly payments.
- You have the ability to take out more than one loan at any one time.
- Fewer obligations and/or a higher income means you have less risk of financial distress.
- Can give you access to better loan terms at lower interest rates.
- A low DTI ratio can improve your personal credit score.
How to Lower Your Debt to Income Ratio
Your debt to income (DTI) ratio measures whether your gross monthly income is sufficient to meet regular monthly debt payments but is also a general indicator of your financial solvency. Naturally, a low debt to income ratio is preferable.
Here are 4 ways to lower your debt to income ratio:
1. Don’t Take Out Additional Loans
Taking out additional loans will only increase your monthly obligations and your debt to income ratio. Try to manage your finances first by paying off existing debts (like credit cards) before you decide to apply for other loans like a long-term mortgage with amortized monthly payments.
2. Increase Your Income
Increasing your income will help improve your debt to income ratio as long as you also don’t increase your debt. If you’re a W2 employee and you can’t get a raise, consider starting a side business or taking on a part-time job to generate more revenue. Lenders will consider this part of your income if you can prove you’ve had it for 2+ years, typically via your tax returns.
3. Consolidate Debts and Pay Them Off Faster
Consolidating your debts together through a debt consolidation loan can help you get better terms and rates, which can allow you to pay off your total obligations faster. This will sometimes result in a higher debt to income ratio in the near-term, but not always. Regardless, the long-term benefit is that you’ll pay your debts faster and lower your debt to income ratio in the long-run.
4. Refinance Existing Debts
It’s sometimes possible to refinance your existing debts at a lower interest rate. This would lower your monthly debt payments and therefore decrease your debt to income ratio. However, sometimes people refinance their loan to pull out an asset’s equity and the resulting new loan may have a higher monthly payment due to the increase in principal amount borrowed.
Bottom Line
The debt to income (DTI) ratio measures the percentage of your monthly debt payments to your monthly gross income. Lenders will usually approve you for a loan if you have a DTI ratio of 43-50% or lower and a good rule of thumb is to keep your debt to income ratio around 36%. You can improve your debt to income ratio by paying off your debts, foregoing additional loans, and/or increasing your monthly income.
