Debt-to-Income (DTI) Ratio: What’s Good and How To Calculate It

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

A debt-to-income (DTI) ratio is a financial metric used by lenders to determine your borrowing risk. Your DTI ratio represents the total amount of debt you owe compared to the total amount of money you earn each month. It is measured as the percentage of your monthly gross income that goes to paying your monthly debt payments.

Formula and Calculation of Debt-to-Income (DTI) Ratio

The DTI ratio is a personal finance measure that compares an individual’s total monthly debt payment to their monthly gross income, which is your pay before taxes and any deductions. It is expressed as a percentage of your monthly gross income that goes to paying your monthly debt payments.

You can use the following formula to calculate your DTI ratio:

DTI Ratio = Total Monthly Debt ÷ Total Gross Monthly Income x 100

Understanding Debt-to-Income (DTI) Ratio

The DTI ratio is one of the metrics that lenders, including mortgage lenders, use to measure an individual’s ability to manage monthly payments and repay debts. A low DTI ratio demonstrates a good balance between debt and income. The lower the DTI ratio, the better the chance that the borrower will be approved or considered for the credit application.

If your DTI ratio is 15%, this means that 15% of your monthly gross income goes to debt payments each month. Conversely, a high DTI ratio can signal that an individual has too much debt for the amount of income earned each month.

Borrowers with low DTI ratios are likely to manage their monthly debt payments effectively. As a result, banks and financial credit providers want to see low DTI ratios before issuing loans to a potential borrower. The preference for low DTI ratios makes sense since lenders want to be sure a borrower isn’t overextended, meaning they have too many debt payments relative to their income.

Debt-to-Income (DTI) Ratio Guidelines

The maximum DTI ratio varies from lender to lender. As a general guideline, 43% is the highest DTI ratio that a borrower can have and still qualify for a mortgage. Ideally, lenders prefer a debt-to-income ratio lower than 36%, with no more than 28% to 35% of that debt going toward servicing a mortgage payment.

Wells Fargo (WFC) is one of the largest lenders in the United States. The bank provides banking and lending products that include mortgages and credit cards to consumers. Below is an outline of its DTI ratio guidelines:

• 35% or less is generally viewed as favorable, and your debt is manageable. You likely have money remaining after paying monthly bills.
• 36% to 49% means your DTI ratio is adequate, but you have room for improvement. Lenders might ask for other eligibility requirements.
• 50% or higher DTI ratio means you have limited money to save or spend. As a result, you won’t likely have money to handle an unforeseen event and will have limited borrowing options.

Limitations of Debt-to-Income (DTI) Ratio

Although important, the DTI ratio is only one financial ratio or metric used in making a credit decision. A borrower’s credit history and credit score will also weigh heavily in a decision to extend credit to a borrower.

A credit score predicts how likely you are to repay your debts. This numeric value is based on information from your credit report, including your payment history, the number of open credit accounts, your balances relative to their credit limits, and any negative remarks like delinquencies.

The DTI ratio does not distinguish between different types of debt and the cost of servicing that debt. For instance, credit cards carry higher interest rates than student loans, but they’re lumped together in the DTI ratio calculation. If you transferred balances from your high-interest cards to one with a lower rate, your monthly payments would decrease. As a result, your total monthly debt payments and your DTI ratio would decrease, but your total debt outstanding would remain unchanged.

How to Lower Your Debt-to-Income (DTI) Ratio

There are several ways to lower your DTI ratio to make yourself more creditworthy and attractive to prospective lenders. The most common way to do so is by reducing your monthly recurring debt by making more than the minimum payment or paying off balances in full. Another way to do so is to increase your monthly gross income.

Consider taking these other actions to help improve this financial metric:

• Negotiate with your creditors
• Consolidate your debt
• Stop your credit card use
  

The DTI ratio can also be used to measure the percentage of income that goes toward housing costs, which for renters is the monthly rent amount. Lenders look to see if a potential borrower can manage their current debt load while paying their rent on time, given their gross income.

Example of Debt-to-Income (DTI) Ratio

John is looking to get a loan and is trying to figure out his debt-to-income ratio. John’s monthly bills and income are as follows:

• Mortgage: $1,000
• Car loan: $500
• Credit cards: $500
• Gross income: $6,000

John’s total monthly debt payment is $2,000:

$\$2,000 = \$1,000 \$500 \$500$$2,000=$1,000 $500 $500

John’s DTI ratio is 0.33:

$0.33 = \$2,000 \div \$6,000$0.33=$2,000÷$6,000

In other words, John has a 33% debt-to-income ratio.

Here are a few scenarios that demonstrate how John can lower his DTI ratio:

• If John’s income is $6,000 but he can pay off his car loan, then his monthly recurring debt payments would fall to $1,500 since the car payment was $500 per month. John’s DTI ratio would be calculated as $1,500 ÷ $6,000 = 0.25 or 25%.
• John's DTI ratio drops if his gross income increases to $8,000. Using the formula above, we determine that his DTI ratio lowers to 0.25 or 25%.
• If John can reduce his monthly debt payments to $1,500 after this increase to $8,000, his DTI ratio would be calculated as $1,500 ÷ $8,000, which equals 0.1875 or 18.75%.
  

Why Is Debt-to-Income Ratio Important?

A debt-to-income ratio is the percentage of your monthly gross income that goes to paying your monthly debt payments and is used by lenders to determine your borrowing risk. A low DTI ratio demonstrates a good balance between debt and income. Conversely, a high DTI ratio can signal that an individual has too much debt for the amount of income earned each month.

Typically, borrowers with low debt-to-income ratios are likely to manage their monthly debt payments effectively. As a result, banks and financial credit providers want to see low DTI ratios before issuing loans to a potential borrower.

What Is a Good Debt-to-Income Ratio?

As a general guideline, 43% is the highest DTI ratio a borrower can have and still get qualified for a mortgage. Ideally, lenders prefer a debt-to-income ratio lower than 36%, with no more than 28%–35% of that debt going toward servicing a mortgage. The maximum DTI ratio varies from lender to lender. However, the lower the debt-to-income ratio, the better the chances that the borrower will be approved, or at least considered, for the credit application.

What Are the Limitations of Debt-to-Income Ratio?

The DTI ratio does not distinguish between different types of debt and the cost of servicing that debt. Credit cards carry higher interest rates than student loans, but they’re lumped in together in the DTI ratio calculation. If you transferred your balances from your high-interest-rate cards to a low-interest credit card, your monthly payments would decrease. As a result, your total monthly debt payments and your DTI ratio would decrease, but your total debt outstanding would remain unchanged.

How Does Debt-to-Income Ratio Differ From Debt-to-Limit Ratio?

Sometimes the debt-to-income ratio is lumped in together with the debt-to-limit ratio. However, the two metrics have distinct differences.

Debt-to-limit ratio, which is also called the credit utilization ratio, is the percentage of a borrower’s total available credit that is currently being utilized. In other words, lenders want to determine if you’re maxing out your credit cards.

DTI ratio calculates your monthly debt payments compared to your income, whereby credit utilization measures your debt balances compared to the amount of existing credit you’ve been approved for by credit card companies.

What Does Credit Utilization Mean?

Credit utilization is a financial metric that measures the amount of credit you use at a particular time compared to the total credit limit. This metric is normally expressed as a percentage. To calculate your credit utilization, divide the sum of all of the outstanding balances of your credit products (credit cards, loans, lines of credit, etc.) by the sum of all their credit limits and multiply the result by 100.

Let's say you have two credit cards with balances of $500 and $2,500 and credit limits of $1,000 and $3,000. Your credit utilization ratio is 75% (($500 + $2,500) ÷ ($1,000 + $3,000) x 100), which is a very high ratio.

The Bottom Line

Debt-to-income (DTI) ratio is the percentage of your monthly gross income (your pay before taxes and other deductions are taken out) that goes to paying your monthly debt payments. Lenders use your DTI ratio to determine your borrowing risk.

A DTI of 43% is usually the highest ratio that a borrower can have and still get qualified for a mortgage; however, lenders generally seek ratios of no more than 36%. A low DTI ratio indicates sufficient income relative to debt servicing, and it makes a borrower more attractive.