Debt-to-Income Ratio

Used to determine the risk of lending the money and examining a company's ability to pay them back while not accumulating more debt

When creditors determine the risk of lending you their money, they use the debt-to-income metric to assess your reliability in paying them back while not accumulating more debt. The DTI is the percentage of gross monthly income spent on repaying recurring monthly debt. 

Debt to income ratio

Lenders like banks, credit unions, online lending platforms, and cash advances use the ratio to ensure they minimize risks when allowing people to borrow money. Usually, a lower ratio leads to lower interest rates, and higher percentages lead to higher interest rates.

Although your DTI does not directly impact your credit score, it is a part of the credit analysis process to determine someone's trustworthiness or credit risk in repaying debt obligations when lenders decide whether or not to reject the loan or application for credit.

In other words, it is an aspect of financial health that helps you understand your financial situation and your ability to manage current debts. For instance, Wells Fargo has its standards on determining who to lend money to, considering which range your ratio falls in.

Understanding the ratio

A lower ratio indicates a good balance that signals credibility to lenders when you ask to borrow money. This is because your monthly debt is less than the gross monthly income, making it more likely for you to repay debts while not adding liabilities

Thus, having a lot of debt does not necessarily mean you will have a high ratio. Instead, it depends on how much income you earn in proportion to the debt obligations you have every month. 

Size

For instance, if your DTI is 30%, then 30% of your gross monthly income goes to paying back your debts. On the contrary, a 70% ratio means that 70% of your gross monthly income goes to debt payments. 

Please note that not everything should be included when finding the sum of monthly debt payments when calculating the ratio. Some exclusions include utility, cable, cell phone bills, health, and car insurances, groceries, food, or any entertainment expenses.

Still, people with lower ratios usually are more effective and proficient in managing their debts, making them more attractive borrowers for financial institutions before issuing loans.

Lenders also use other metrics to determine if someone is creditworthy and has low credit risk, including credit score and report, income and employment history, collateral value for the security of a loan in case of a default, size of down payment, liquidity of assets, and loan term.

importance

Usefulness

Banks and lenders look at borrowers' DTI to see if they properly manage their monthly expenses while having a steady monthly gross income. A low ratio shows a good debt and income balance, lowering lenders' borrowing risk.

However, a high ratio shows that the borrower has a lot of debt relative to their gross monthly income, making the lenders more hesitant to lend the money because they are unsure if the borrower will be able to repay the loan.

What is a good ratio?

As a recommendation by the Consumer Financial Protection Bureau (CFPB), lenders usually use a DTI of 36% as an upper limit to what is considered a "good" ratio. Therefore, it is best to keep it under the 36% mark. 

As for a "bad" ratio, the CFPB states that, in most cases, for a qualified mortgage, 43% is the highest one can have.

For renters, the CFPB recommended range is 15% to 20%, if not lower. When calculating the number in this scenario, the CFPB suggests not including the rent payment.

However, regardless of the numbers above, please note that the threshold for an acceptable number varies by lender.

Requirements for Mortgage Loans

There are specific requirements for ratio depending on the different mortgage loan options you are pursuing. However, loans back by Fannie Mae and Freddie Mac typically set the bar at 43% or lower. In 2020, though, Fannie Mae raised the maximum acceptable ratio to 50%.

Requirements

Conventional loans depend on a case-by-case situation, but the general ratio accepted falls under 50%, with some conditions allowing the percentage to be 65% through refinancing.

FHA loans are a lenient loan option backed by the US Federal Housing Administration that allows the ratio to be as high as 57%, but usually around 50%.

USDA loans require a ratio of less than 41% to 46% and are only eligible in rural areas for buying and refinancing homes. Another standard for eligibility is that the household income, including everyone, must not exceed 115% of the median income in your region.

VA loans are insured by the Department of Veterans Affairs and designed for current and former Armed Forces members for home purchases. The loan is low-cost and does not require a down payment, with a maximum ratio allowed up to 60%.

Jumbo loans usually have high credit quality but are for financing expensive properties exceeding conventional conforming loan limits, with the max debt-to-income being around 43%.

There are ways to compensate and qualify for these loans with a high ratio, including having additional savings or reserves, proof of on-time payment records, or a letter explaining strategies in which the applicant or borrower is aiming to manage the debt obligations.

Loan usages

Tips for Applying and Qualifying for Mortgages 

Consulting with lenders for financial advice, understanding debt-to-income, lowering debt obligations, reducing spending habits on unnecessary goods or services, and not taking out new loans before buying a property can help lower the ratio and increase the chances of approval.

Front-End vs. Back-End Ratios

There are two types, front-end, and back-end.

1. Front-end 

We use the front-end to calculate the gross income used for housing costs by adding up housing expenses like principal, interest, mortgage payments, property taxes, and homeowner's insurance and dividing it by their gross income.

For example, if the homeowner earns a monthly gross income of $6,000 but has a monthly mortgage payment of $1,800, they would have 30% as their front-end DTI.

Front and back end ratios

2. Back-end 

As for the back-end, we use it when we want to calculate the amount of gross income used for paying all monthly debts, including monthly rent, child support expenses, credit card payments, and car loans. 

For example, if an individual has a monthly gross income of $8,000 with a monthly debt total of $2,400 ($400 in credit card payments, $1,000 in mortgage payments, and $1000 in car loans), they would have a back-end DTI of 30%. 

Which Matters More?

Although mortgage lenders look at both components, the back-end is more vital because it includes the total debt obligations in most cases.

Formula and Calculation

Calculation

To calculate, we need to add all the monthly debt payments and divide them by the gross income. Then, to find the percentage, multiply the quotient by 100%, as depicted below:

DTI = Monthly Debt Payments/ Gross Monthly Income * 100%

  • Monthly debt payments include rent, mortgage, car or student loans, homeowner's insurance, credit card payments, medical bills, and so on. Expenses like utility bills (electricity, water, gas) and health or medical insurance are not included.
  • Gross income is one's total earnings, including capital gains, interest, dividends, and pensions, before deductions like tax.

Here is a quick video of how to calculate debt to income ratio:

1. Practical Example

Bob currently pays $1,000 for student loans, $4,000 for a mortgage, and $200 in monthly credit card payments while having a gross monthly income of $10,000.

To calculate the percentage, we can use the equation presented above by adding up all the monthly debts and dividing it by the monthly gross income:

Practical example

From the equation, we find that Bob has a DTI of 52%, which means he needs to take action to reduce his debts or increase his income because most lenders would want applicants with lower ratios and higher creditworthiness.

2. Real-Life Example

Suppose that Bob, from the previous example, is considering borrowing from JPMorgan Chase. Is his ratio of 52% good enough for the bank to lend him money?

Here is an outline of Chase Bank's guideline for assessing the creditworthiness concerning an individual's ratio:

A general rule of thumb: keep the number below 43%, which is the maximum ratio eligible for a Qualified Mortgage – a form of loan that is stable and borrower-friendly.

  • 36% or less is a very healthy ratio with a high income for savings or investments with relatively few monthly liabilities – a safe signal for banks to lend you money.
  • 36% to 41% show that the individual has manageable debt, but the percentage is a little high if the borrower is seeking larger loans or trying to borrow from strict lenders.
  • 42% to 49% indicate there are unmanageable levels of debt compared to income, making lenders wary of lending you money because they doubt the individual can repay them.
  • 50% or more means the individual is struggling to meet debt obligations, and lenders will not be willing to loan the individual money unless they reduce debt or increase income.

Limitations

Even though financial institutions use the DTI to assess an individual's credit risk and creditworthiness, it does not decipher the types of debt and the expenses needed to manage those debt obligations or payments.

For example, personal loans have higher interest rates than home-equity loans, but they are all grouped when calculating the ratio. The same applies to credit cards, where transferring a balance from a higher to a lower-interest credit card would decrease spending.

Limitations

Consequently, although the percentage outcome may have decreased given the transfers, the total debt remains the same, providing a false representation of your financial health and ability to manage debts.

Because of these limitations, you would want to budget above what is considered affordable or financially sensible based on your debt-to-income and make decisions based on your actual income when considering all expenses.

Ways to Lower the ratio

Lower

There are two main ways to lower your ratio: 

1. Decrease Monthly Debt Payments 

If possible, reduce any monthly recurring debts you can, first by organizing them and prioritizing payments, and then consolidating them. This way, the ratio will lower if the gross monthly income remains the same. Here are some specific methods to do so:

  • Lower interest rates on debts: try to transfer balance through credit card, refinancing (including personal loans, auto loans, and mortgages), or calling to negotiate with creditors
  • Extend the duration of the loan (this may lead to higher interest rates)
  • Pay off high-interest debts so that the DTI and credit utilization ratios can decrease (you can use a debt snowball calculator for reference)
  • Control non-essential spending to cut down on monthly expenses and prioritize repaying debts 
  • Find alternatives for high-interest loans 

2. Increase Gross Income 

If decreasing debts is not possible, look for ways to increase your monthly income, such as finding a part-time job for side income. 

Mortgages 

In the case of purchasing a property, larger down payments can help reduce the ratio and lower monthly mortgage payments to increase affordability.

Differences Between Debt-to-Income and Credit Utilization Ratio (Debt-to-Limit)?

The credit utilization ratio, otherwise credit utilization rate or debt-to-limit, is the amount of revolving credit currently used divided by the total revolving credit someone has. This could also be interpreted as the current amount owed divided by the credit limit in percent form. 

Credit Utilization = Total Balance/ Total Credit Limit * 100%

We can use Bob as an example to calculate credit utilization. Suppose that Bob has three credit cards, A, B, and C, with the corresponding balance of $2,000, $4,000, and $7,000 and a credit limit of $6,000, $8,000, and $15,000. 

Utilization formula

The above quotient arrives at roughly 44.8%, above the recommended rate of 30% – the threshold separating the "good" credit utilization from the bad. As a general rule, you should never exceed the 50% mark. 

Still, it is wise to keep the rate low. A high balance, a part of credit utilization, can harm one's credit score through reports (Equifax, TransferUnion, or Experian) and impact the FICO score.

Although lenders use both credit utilization and debt-to-income before issuing a loan, the credit utilization ratio helps to determine if you are using up all your credits by looking at your credit limit, whereas debt-to-income looks at gross monthly income.

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Researched and authored by Max Guan I LinkedIn

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