What Is Debt-to-Income Ratio and How Do I Calculate It?

What Is Debt-to-Income Ratio?

Your debt-to-income ratio, often called DTI, is how much of your gross income goes toward debt payments every month. From a lender’s perspective, it shows how much more debt you can reasonably take on, given your current income and debt situation.

There are two types of DTI that you may run into:

• Front-end DTI: Represents only your monthly housing costs and how they relate to your gross monthly income. If you’re a renter, it includes your monthly rent payment. But if you’re a homeowner, it may include your loan payment as well as monthly costs for mortgage insurance, homeowners insurance and property taxes.
• Back-end DTI: Includes all your monthly debt obligations, including personal loans, student loans and credit card payments.

Most lenders use back-end DTI only, but mortgage lenders typically use both. The higher your ratio is, the more risk you pose to a lender because it may be more difficult for you to keep up with your payments compared with a low-DTI borrower.

If your DTI is relatively high, a lender may charge a higher interest rate to compensate for their added risk. You may even be denied because your DTI is too high.

How Is Debt-to-Income Ratio Calculated?

To calculate your debt-to-income ratio, establish what your total monthly debt obligation is and divide that figure by your gross monthly income.

For example, if each month you pay the following:

• Rent: $1,000
• Auto loan: $250
• Student loan: $100
• Other debt: $200

The sum of all your monthly payments is $1,550. To calculate your gross monthly income, take your salary before taxes and other deductions, and divide it by 12. So if your annual salary is $60,000, your gross monthly income would be $5,000.

Now take your total monthly debt obligations ($1,550) and divide them by your gross monthly income ($5,000). Then convert the resulting number (0.31) into a percentage by multiplying it by 100; in this case, 31% is your DTI.

If you’re buying a house and applying for a mortgage loan, the lender will use the calculations above to calculate your back-end DTI but will also consider your front-end DTI. To calculate that, simply divide the proposed mortgage payment, say $1,200, by your gross monthly income ($5,000), and you’ll get 0.24, or 24%.

What Is a Good Debt-to-Income Ratio?

Generally, the lower your DTI, the better, because this shows lenders you have the extra income after your current debt obligations to take on new loan payments.

The ideal DTI, however, depends on the type of loan you’re applying for and the lender. Here are some guidelines:

• Mortgage loans: Lenders may look for a front-end DTI of 28% or lower—the maximum for an FHA loan is 31%—and a back-end ratio of less than 43% (though sometimes less than 36%). Conventional loan guidelines by Fannie Mae and Freddie Mac allow for back-end DTIs as high as 50% in some circumstances.
• Other loans: Other loan types are available to borrowers with a DTI of 50% or less, though that maximum can vary by lender.

While it’s important to work to reduce your DTI, remember that it’s not the only factor lenders evaluate. They’ll also look at your credit reports and credit scores, your employment situation and other important factors.

As you consider how to improve your chances of getting approved for a loan with favorable terms, be sure to look at the whole picture and how you can present as low of a risk as possible to future lenders.

How Does Debt-to-Income Ratio Affect Credit?

Your DTI doesn’t directly affect your credit scores because credit scoring models ignore income information. However, how much you owe plays a factor in your credit utilization rate, which is the second-most influential factor in your FICO Score.

Your credit utilization rate is your credit card balances divided by total credit limits. It indicates how much of your available credit you’re using. Credit experts recommend keeping your utilization rate below 30%, and the lower it is, the better.

But your DTI also includes how much you owe on other types of credit accounts, including installment loans and other revolving credit lines. The more debt you’re carrying on credit cards and other loans, and the higher your utilization rate, the more negatively it can impact your credit scores.

Monitor Your DTI and Your Credit For Better Access to Credit

Even if you don’t anticipate needing to apply for credit anytime soon, it’s a good idea to keep an eye on your DTI and your credit score to make sure you’re ready when you need it. To monitor your DTI, keep a running list of your debt payments and calculate your DTI whenever you pay off a loan or credit card or take on new credit.

For your credit score, you can use Experian’s free credit monitoring service, which provides access to your Experian credit report and FICO Score. You’ll also get real-time alerts whenever changes are made to your credit report, so you can track your progress and spot potential issues before they wreak havoc on your credit health.