Debt-to-Income (DTI) Ratio Definition

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

The debt-to-income (DTI) ratio measures a person’s total amount of debt versus their gross income. It is calculated by dividing an individual’s total monthly debt payments by their total monthly income (based on the average annual income declared on the last two tax returns) before taxes and other deductions.

REtipster does not provide tax, investment, or financial advice. Always seek the help of a licensed financial professional before taking action.

Why Is the DTI Ratio Important?

dti ratio

The DTI ratio is one of the lending ratios lenders use for credit analysis[1]. Therefore, it is beneficial for both lenders and borrowers to understand how it is calculated and why it matters.

For lenders, the DTI ratio allows them to assess the amount of inherent risk in a loan applicant. When an applicant has a low DTI ratio, it can signal that a person is in a good position to handle a new financial obligation. A high DTI ratio can indicate that a prospective borrower does not have sufficient income to fit another loan payment into their monthly expenses.

By taking the DTI ratio into consideration, lenders are able to approve or deny loan applications based on whether the loan applicant has the financial capacity to afford the added debt service. If the DTI ratio is not taken into consideration, a borrower would easily acquire more debt than they can realistically manage.

What Is a Good DTI Ratio?

In the mortgage industry, 43% is commonly used as a baseline for an acceptable DTI ratio[2]. Typically, this is the highest DTI ratio a borrower can have and still have a chance at getting approved for a qualified mortgage. For that reason, any figure below 43% can be considered a good DTI ratio.

However, 43% is higher than the maximum DTI limits of some loans, while some home loans have a friendlier view of higher debt ratios. Have a look at the historical max DTI ratios for the different home loans below[3].

Home Loan Maximum DTI Ratio (front- and back-end)
Conventional 28% and 36%
Conforming (Fannie Mae and Freddie Mac) 28% and 43%
FHA* 31% and 43%
VA** 41%
USDA*** 29% and 41%

* – May allow higher DTI ratio limits under certain circumstances
** – Involve only one DTI ratio and may extend limit up to 50% with compensating factors like a higher minimum credit score requirement
*** – May allow higher DTI ratio limits with compensating factors

To larger conventional lenders, the above figures may be mere recommendations. At their discretion, they may issue loans to severely indebted applicants, provided that they exercise due diligence, follow the rules set by the Consumer Financial Protection Bureau, and make the decision in good faith.

Moreover, auto loan lenders are particular about DTI ratios as well[4]. When seeking funding for a new car purchase, the preferred DTI ratio is below 36%, but these creditors are often willing to negotiate. For auto refinancers, many car loan lenders tend to approve debt ratios as high as 48%.

In other words, a good DTI ratio is relative, and maximum debt ratio limits are not always set in stone.

Front- and Back-End DTI Ratios

Mortgage lenders may calculate for two percentages: front-end and back-end DTI ratios. Some mortgage products require the two DTI ratios to qualify borrowers, but most lenders tend to place more importance on the back-end figure[5].

  • Front-end DTI ratio: accounts for a prospective borrower’s projected monthly home loan payment only. Also known as “housing ratio.”
  • Back-end DTI ratio: accounts for all of the monthly liabilities, including the projected monthly home loan payment. Also known as “total ratio.”

Take these details as an example for a borrower:

  • Gross annual income: $60,000
  • Gross monthly income: $5,000
  • Monthly liabilities: $2,500
  • Projected home loan payment: $1,200

Based on the figures above, this borrower’s front-end DTI ratio would be 24% ($1,200/$5,000), and their back-end DTI ratio would be 50% ($2,500/$5,000).

What Is Included in the DTI Ratio?

The “D” in DTI stands for debt, but most lenders ignore non-credit-related expenses when calculating a loan candidate’s DTI ratio.

In general, financial institutions take the payments to the following types of debt into account when reviewing the credit reports of prospective borrowers[6]:

  • Auto loans
  • Cosigned loans
  • Credit cards
  • Home equity loans
  • Mortgages (principal, interest, homeowners insurance, and property tax)
  • Personal loans
  • Student loans

In addition, these are other financial obligations lenders might be interested in:

  • Auto lease
  • Child support
  • Homeowners’ association dues
  • Spousal maintenance or alimony
  • Timeshare payments

The list of some lenders may be longer than others, so the actual DTI calculation may differ from one financial institution to another.

What Is Not Included in the DTI Ratio?

Not every monthly expense counts against a person’s income when determining the DTI ratio, however. Below are the regular bills lenders take out of the equation.

  • Auto insurance
  • Cable
  • Health insurance
  • Home utilities
  • Phone
  • Rent

Also, some lenders remove charge cards from consideration since the holders of these credit cards must zero out their balances at the end of the month.

Financial institutions may also exclude expenses related to gardening, pool cleaning, and the like from the DTI ratio.

Does the DTI Ratio Affect Credit Scores?

The DTI ratio does not affect credit scores[7].

The DTI ratio, regardless of how high or low it is, cannot directly influence a person’s credit scores. Credit bureaus do not have access to information about people’s earnings, so there is no way for them to compare the size of the debt against the gross monthly income of a person.

Credit-reporting agencies can only score people’s ability to manage what they owe to predict their likelihood of defaulting on future debts.

The major credit bureaus—Experian, TransUnion, and Equifax—do not use the same credit-scoring models[8], which may weigh factors differently. Although these entities score the creditworthiness of consumers in their own way, they all agree on the importance of these five criteria:

  • Payment history
  • Debt level
  • Age of credit accounts
  • Diversity of credit
  • Credit inquiries

Credit scores are insightful, but they cannot paint an accurate picture of the creditworthiness of mortgage applicants alone. Neither can DTI ratios. That is why lenders look at both figures, among others, before making credit decisions.

DTI Ratios and Related Terms

Some concepts and terms are related to the DTI ratio, including the payment-to-income (PTI) ratio and the debt-to-limit (DTL) ratios. We differentiate between them below.

DTI vs. PTI

Not all financial institutions value the DTI ratio; some auto lenders, for instance, prefer the PTI ratio. Rather than determining a person’s debt level, the PTI ratio simply counts one’s monthly car payment against pre-tax monthly income. Compared to the DTI ratio, the PTI ratio is more attractive to some creditors because it is simple to calculate.

The PTI ratio is not an exact science. But it is good enough for creditors who think that a person whose projected monthly car payment is no more than 20% of the gross monthly income[9] is a safe auto loan candidate.
In any case, the logic behind the PTI ratio has some holes. For example, a person may have high income but in a deep financial hole; their PTI is more attractive, but they are less likely to become a punctual auto loan payer.

dti credit

DTI vs. DTL

Also known as credit utilization, balance-to-limit ratio, and debt-to-credit ratio, the debt-to-limit (DTL) ratio calculates one’s total outstanding debts against the combined credit limits[10].

This metric applies to lines of credit like credit card accounts. Since it focuses on credit usage, it is an essential component in the calculation of credit scores. It can reveal how much a person depends on credit to get by. The highest DTL ratio considered healthy is 30%.

The DTI ratio is much closer to the DTL ratio than it is to the PTI ratio. The DTI ratio provides a more comprehensive picture of a person’s indebtedness since it includes installment loans in its calculation. But the DTL ratio may shed more light on one’s tendency to max out available credit.

Limitations of the DTI Ratio

The DTI ratio is useful for measuring one’s level of indebtedness, but it does not tell the whole story of whether a loan applicant should be approved.

The DTI ratio treats all types of credit as the same and fails to identify the cost of servicing different debts. The DTI ratio calculation merely lumps all monthly liabilities together, not separating the principal from the interest.

In theory, people can lower their DTI ratios without necessarily reducing their level of indebtedness. Combining high-interest and low-interest debts might create a false sense of creditworthiness.

Furthermore, a sound debt consolidation strategy could skew the result of a DTI ratio calculation. For example, moving balances from high-interest credit cards to a low-interest one could drive down a person’s debt ratio even if the total amount owed stayed the same.

Takeaways

The DTI ratio is a metric useful for determining the financial capacity of a person to manage more debt. It does not directly impact credit scores; rather, it complements them.

The DTI ratio has inadequacies, so it does not provide a complete evaluation of a person’s creditworthiness on its own. That is why most lenders use it along with other metrics to size up the readiness of a loan applicant to take out new debt.

Sources

  1. Corporate Finance Institute. (n.d.) What are Lending Ratios? Retrieved from https://corporatefinanceinstitute.com/resources/knowledge/finance/lending-ratios/
  2. Anas, B. (2020.) Why Experts Say 43 Is the Magic Number Potential Homeowners Should Know. Apartment Therapy. Retrieved from https://www.apartmenttherapy.com/debt-to-income-ratio-36701674
  3. Loans101. (2017.) Mortgage Debt-to-Income Ratio – Conventional, FHA, VA, USDA Loan DTI. Retrieved from https://www.loans101.com/loan-requirements/mortgage-debt-to-income-ratio-dti/
  4. Jones, J. (2020.) Debt-to-Income Ratio for Car Loans: What to Know. LendingTree, ed. Shepard, D. Retrieved from https://www.lendingtree.com/auto/debt-to-income-ratio-for-car-loan/
  5. Buczynski, B. (2019.) Understanding Debt-to-Income Ratio for a Mortgage. NerdWallet. Retrieved from https://www.nerdwallet.com/article/mortgages/debt-income-ratio-mortgage
  6. Crace, M. (2021.) Debt-To-Income Ratio (DTI): What Is It And How Is It Calculated? Rocket Mortgage. Retrieved from https://www.rocketmortgage.com/learn/debt-to-income-ratio
  7. Irby, L. (2020.) 5 Factors That Affect Your Credit Score. The Balance, ed. Estevez, E. Retrieved from https://www.thebalance.com/factors-affecting-credit-score-960527
  8. Akin, J. (2020.) What Is a Credit Report? Experian. Retrieved from https://www.experian.com/blogs/ask-experian/what-is-a-credit-report/
  9. Carbary, M. (2018.) What’s a Payment to Income Ratio? CarsDirect. Retrieved from https://www.carsdirect.com/auto-loans/whats-a-payment-to-income-ratio
  10. Dixon, A. (2018.) What Is a Debt-to-Credit Ratio? SmartAsset. Retrieved from https://smartasset.com/credit-cards/debt-to-credit-ratio

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