What is debt to income ratio & How to calculate it for your home loan

This debt to income ratio is dependent on your own debt obligations and earnings, as its name implies. The amount is an indication of your ability for borrowing and to make payments on a new loan and any present debts.

Because this amount can make or break your next loan application, it’s important to understand debt to income ratio . You can even calculate your debt to income, sometimes called DTI, to see how you stand. Read this guide to learn more.

What does debt to income ratio mean?

The debt-to-income (DTI) ratio is a personal finance measure that compares an individual’s monthly debt payment to his or her monthly gross income. Your gross income is your pay before taxes and other deductions are taken out. The debt-to-income ratio is the percentage of your gross monthly income that goes to paying your monthly debt payments.

Another way to consider debt-to-income is the recurring debt obligations as a percentage of your monthly income. A greater percentage of debt compared to income causes a higher DTI. A higher debt to income is regarded as a bigger risk by lenders.

debt to income ratio
debt to income ratio

Your debt-to-income ratio usually includes the following debts at minimum:

  • Mortgage loan and auto loan payments
  • Student loan payments
  • Credit card payments
  • Other items you may have financed that report to the credit bureaus
  • Other personal loans

This ratio doesn’t generally contain other living expenses, home costs, utilities, property taxes and other expenses which aren’t typically included in your credit report.

How to calculate your debt-to-income ratio?

Calculating your debt to income ratio is simple. If you’re able to do basic addition and division using the calculator in your phone, or another calculator, you can calculate your DTI.

To begin, you will need to know your yearly income before taxes and deductions. If you do not know this number, you’ll find it on a pay stub or your latest W-2 form used to file your taxes.

Next, you will need to locate your total monthly minimum debt payments. You will find this in your credit file, which you can usually get a version of for free from sites like Credit Karma, Credit Sesame, or perhaps your bank.

When I worked as a bank supervisor, I used the minimum monthly payment on the credit report but didn’t include debts in which the applicant has been a licensed user.

Add up your monthly payments in your credit report and divide by your gross monthly income to receive your debt to income ratio. By way of instance, if you earn $40,000 per year that is exactly the same as $3,333.33 per month. If you have $500 in monthly debt payments, then your debt-to-income will be 500/333.33 = .15. In cases like this, your DTI is .15 or 15%.

If this looks too complicated, here is a handy little debt-to-income ratio calculator you may use.

debt to income ratio
debt to income ratio

Debt-to-income along with your credit score

Contrary to the belief of some, your income does not have any direct effect at all on your credit rating. You may make nothing and have a perfect credit rating or make six-figures and have a terrible credit rating.

Your credit score is just based on your existing debt and history of debt obligations and credit-related records. Your earnings only influences your credit , as it affects your ability to pay for your loans every month. But ultimately, it’s your debt accounts, debt history and any history of public records which constitute your credit score.

Your debt-to-income ratio will likely follow your credit utilization ratio carefully, which is a metric used on your credit score. Credit utilization is the percentage of credit used in connection with your credit limits.

How lenders use the debt-to-income ratio?

Most mortgage lenders require a debt to income ratio of 43 percent or lower, though some prefer a DTI of 36% so that you have some flexibility to receive your application through. A higher down payment lowers your monthly payment if you’re fighting to get approved.

As a rule of thumb, a DTI lower than 30 percent is deemed good by creditors in most industries. Each creditor has its own specific requirements and principles for what it counts and what gets eliminated when calculating a client’s allowable ratio and approving a new program.

Never lose track of your DTI

Your debt-to-income ratio is probably not inclusive of all monthly costs, so it’s just 1 estimate used to decide whether you’re able to afford a loan and will likely pay it back. The lender will use your own credit report, credit score, debt-to-income ratio, along with other aspects to accept any new loan application. No creditor would make any decision with a single consideration in summary.

By keeping an eye on your debt-to-income ratio, in addition to your overall monthly living expenses, you’ll be in the best position to qualify for whatever future loan you’re looking for. But do not lose track of your credit rating or other facets of your finances. It takes the complete package to really master your money.