Debt to income ratio is a financial term used to describe the percentage of an individual’s monthly income that goes towards paying debts. This figure provides creditors with an indication of an individual’s ability to make debt repayments, and is therefore an important factor in credit decisions. A high debt to income ratio may result in an individual being refused credit, or being offered less favorable terms such as a higher interest rate.
There are two types of debt to income ratio: front-end and back-end. Front-end debt to income ratio includes only housing-related expenses such as mortgage payments or rent. Back-end debt to income ratio includes all monthly debts including credit card payments, car loans, personal loans and any other form of borrowing.
Debt to Income Ratio for Mortgage Approval
Lenders use debt to income ratio (DTI) to decide how much mortgage you can afford. They want to loan you enough money so that your monthly debt obligations, including your new mortgage payment, equals no more than 43% of your gross monthly income.
Debt to income ratio formula for mortgage:
Step 1: Add up all your monthly debts including your new mortgage payment, car payment, credit card payments, student loans, etc.
Step 2: Take your annual gross income and divide it by 12 to get your monthly gross income
Step 3: Divide your total monthly debts by your monthly gross income
For example, if your monthly debts are $1,500 and your monthly gross income is $5,000, your debt to income ratio would be 30%.
($1,500/$5,000 = .30 or 30%)
Debt to Income Ratio for a Car Loan
For a car loan, your debt-to-income (DTI) ratio can’t be more than 10%. That means if your monthly income is $3,000, the most you could afford to pay for a car loan and still have money left over for other things each month would be $300.
Your DTI ratio is made up of two parts:
The front-end ratio is your monthly housing expenses divided by your monthly gross income.
The back-end ratio is all of your monthly debt payments divided by your monthly gross income.
Debt to income ratio formula for car loan:
Step 1: Add up all of your monthly debts including your car payment, credit card payments, student loans, etc.
Step 2: Take your annual gross income and divide it by 12 to get your monthly gross income
Step 3: Divide your total monthly debts by your monthly gross income
For example, if your monthly debts are $500 and your monthly gross income is
Debt to Income Ratio for a Personal Loan
For a personal loan, your debt-to-income (DTI) ratio can’t be more than 40%. That means if your monthly income is $3,000, the most you could afford to pay for a personal loan and still have money left over for other things each month would be $1,200.
Debt to income ratio formula for car loan:
Step 1: Add up all of your monthly debts including your personal loan payment, credit card payments, student loans, etc.
Step 2: Take your annual gross income and divide it by 12 to get your monthly gross income
Step 3: Divide your total monthly debts by your monthly gross income
For example, if your monthly debts are $800 and your monthly gross income is $3,000, your DTI ratio would be 800/3000 = 0.27 or 27%.
What is Considered a Good Debt to Income Ratio?
In general, the lower your DTI ratio, the better. A ratio of 43% or less is considered excellent and usually allows you to qualify for the best interest rates. A ratio between 43% and 50% is still good and may not hurt your chances for approval, but you might not get the best rates. Ratios of 50% or more are considered subprime and will make it difficult to get approved for a loan or credit card.
If your debt to income ratio is too high, there are a few things you can do to improve your chances of getting approved for a loan or credit card. One option is to pay down your existing debt so that your ratio is lower. Another option is to increase your income by finding a better paying job or taking on a side hustle. You could also try to negotiate with your creditors for lower monthly payments.
Debt to income ratio is just one of many factors considered by creditors when making credit decisions, and is not the sole determining factor. Other factors may include credit history, employment status and income. For more information on debt relief and debt consolidation, let the experts at Americor take you through some potential options that are in line with your specific financial needs.