The debt to income ratio is a personal finance measurement that calculates what percentage of income debt payments make up by comparing monthly payments to monthly revenues. In other words, it shows us what percentage of your income is being paid out in monthly debt payments for credit cards, loans, and mortgages.
This is measurement used by almost all personal lenders, but it is particularly common in the mortgage industry. Mortgages brokers want to make sure you are capable of managing your current debt and paying your potential monthly mortgage payments before they issue you a loan. Essentially, they use this measurement to see if your income is high enough to cover the new mortgage payments as well as the your current monthly payments. To do this, they must look at your current income and current monthly debt payments.
Although, there are many other factors involved in qualifying for a personal loan like credit score, employment status, and personal assets, none of them matters if your income is too low to cover the total monthly debt payments.
Let’s take a look at how to calculate the debt-to-income ratio for a mortgage.
Formula
The debt to income formula is calculated by dividing total monthly debt payments by gross monthly income.
This is a pretty simple equation that really puts it in perspective how much money you are actually paying out each month in debt payments. Mortgage companies tend to modify this equation by leaving your mortgage payment out of the numerator. This lets the calculate your DTI based on your regular monthly debt to figure out what mortgage payment you will be able to afford while still having enough money left over for monthly living expenses aside from your monthly debt payments.
Analysis
A lower debt-to-income ratio is always better than a higher one because this indicates that your monthly debt payments are a smaller percentage of your monthly income. With lower debt payments you are able to afford a larger mortgage payment or more living expenses.
Standard acceptable DTIs change over time based on the industry, geographical location, and the prime interest rate. For example, someone purchasing a home in Southern California will probably have more flexibility in their DTI than some rural Michigan because home prices are higher in California and more likely to appreciate.
They also vary among different lenders. Remember, this is essentially a risk measurement. The lender uses this measurement to see if you can afford the mortgage. The higher the ratio, the less likely it is that you will be able to afford the monthly payments. Some lenders are willing to issue riskier loans at a higher interest rate, while others have strict standards on what DTI they are willing to accept.
Let’s take a look at an example.
Example
Let’s assume you are applying for a mortgage to buy a vacation home. Who doesn’t want a vacation home, right? Your monthly credit card bills are $1,000 per month and your monthly car loan payments are $500. You also have a monthly mortgage payment of $1,500 on your primary residence. This brings your total monthly debt obligations to $3,000. If your annual income were $60,000, we would calculate your debt to income ratio like this:
As you can see, your DTI is 60 percent. This is extremely high for almost any industry or lender. You probably wouldn’t be able to get a second mortgage with this high of a ratio.
If you were able to buckle down for a while and pay off your car and credit cards, your monthly debt payments would only be $1,500 bringing your DTI down to 30 percent. This is still on the high side, but it is much more attractive than 60 percent.
Now let’s assume you got a big promotion and a salary increase to $75,000. With you credit card and car loans paid off and this new, higher salary, your DTI would only be 24 percent. This might be low enough to qualify for a second mortgage.
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Shaun Conrad is a Certified Public Accountant and CPA exam expert with a passion for teaching. After almost a decade of experience in public accounting, he created MyAccountingCourse.com to help people learn accounting & finance, pass the CPA exam, and start their career.
FAQs
Divide your projected monthly mortgage payment by your monthly gross income to calculate a front-end DTI. Divide all your monthly debt payments, including your projected monthly mortgage payment, by your monthly gross income to calculate a back-end DTI.
How is the debt-to-income ratio calculated? ›
How do I calculate my debt-to-income ratio? To calculate your DTI, you add up all your monthly debt payments and divide them by your gross monthly income. Your gross monthly income is generally the amount of money you have earned before your taxes and other deductions are taken out.
What is a debt ratio and how is it calculated? ›
A debt ratio measures the amount of leverage used by a company in terms of total debt to total assets. This ratio varies widely across industries, such that capital-intensive businesses tend to have much higher debt ratios than others. A company's debt ratio can be calculated by dividing total debt by total assets.
How to calculate debt ratio calculator? ›
Here's a simple two-step formula for calculating your DTI ratio.
- Add up all of your monthly debts. ...
- Divide the sum of your monthly debts by your monthly gross income (your take-home pay before taxes and other monthly deductions).
- Convert the figure into a percentage and that is your DTI ratio.
The front-end DTI is typically calculated as housing expenses (such as mortgage payments, mortgage insurance, etc.) divided by gross income. 2. A back-end DTI calculates the percentage of gross income spent on other debt types, such as credit cards or car loans.
What is a realistic debt-to-income ratio? ›
35% or less: Looking Good - Relative to your income, your debt is at a manageable level. You most likely have money left over for saving or spending after you've paid your bills. Lenders generally view a lower DTI as favorable.
What is the debt-to-income ratio based on salary? ›
To calculate debt-to-income ratio, divide your total monthly debt obligations (including rent or mortgage, student loan payments, auto loan payments and credit card minimums) by your gross monthly income. What is a good debt-to-income ratio? A debt-to-income ratio of 36% is generally considered manageable.
Why do we calculate debt ratio? ›
Investors use the ratio to evaluate whether the company has enough funds to meet its current debt obligations and to assess whether it can pay a return on its investment. Creditors use the ratio to see how much debt the company already has and whether the company can repay its existing debts.
What's a good debt ratio? ›
This compares annual payments to service all consumer debts—excluding mortgage payments—divided by your net income. This should be 20% or less of net income. A ratio of 15% or lower is healthy, and 20% or higher is considered a warning sign.
What is the formula for long term debt ratio? ›
Long Term Debt Ratio = Long Term Debt ÷ Total Assets
The sum of all financial obligations with maturities exceeding twelve months, including the current portion of LTD, is divided by a company's total assets.
You collect all your long-term debts and add their balances together. You then collect all your short-term debts and add them together too. Finally, you add together the total long-term and short-term debts to get your total debt. So, the total debt formula is: Long-term debts + short-term debts.
What is a debt-to-income ratio foolproof? ›
What is the best explanation of "debt-to-income" ratio? The ratio of how much money individuals owe in relation to how much money they make.
How to calculate front-end debt-to-income ratio? ›
To calculate the front-end ratio, follow the steps below.
- Add your total expected housing expenses. This includes the principle and interest mortgage payment, taxes, insurance and any HOA dues.
- Divide your housing expenses by your gross monthly income.
- Multiply that number by 100. The total is your front-end DTI ratio.
The back-end ratio is calculated by adding together all of a borrower's monthly debt payments and dividing the sum by the borrower's monthly income and multiplying by 100.
Do you include rent in debt-to-income ratio? ›
Your debt-to-income ratio (DTI) compares how much you owe each month to how much you earn. Specifically, it's the percentage of your gross monthly income (before taxes) that goes towards payments for rent, mortgage, credit cards, or other debt.
What are the 4 C's of credit? ›
Character, capital, capacity, and collateral – purpose isn't tied entirely to any one of the four Cs of credit worthiness. If your business is lacking in one of the Cs, it doesn't mean it has a weak purpose, and vice versa.
What is the 28 36 rule? ›
According to the 28/36 rule, you should spend no more than 28% of your gross monthly income on housing and no more than 36% on all debts. Housing costs can include: Your monthly mortgage payment. Homeowners Insurance. Private mortgage insurance.
What is a good debt ratio? ›
From a pure risk perspective, debt ratios of 0.4 or lower are considered better, while a debt ratio of 0.6 or higher makes it more difficult to borrow money. While a low debt ratio suggests greater creditworthiness, there is also risk associated with a company carrying too little debt.
Does monthly debt include groceries? ›
More in depth: Monthly Debt Service is a potentially misleading term, as it is limited to certain monthly debts. It does not include health insurance, auto insurance, gas, utilities, cell phone, cable, groceries, or other non-recurring life expenses.
What is the ideal mortgage to income ratio? ›
The most common rule for housing payments states that you shouldn't spend more than 28% of your gross income on your housing payment, and this should account for every element of your home loan (e.g., principal, interest, taxes, and insurance).
