How to calculate the debt to income ratio?

The debt-to-income ratio is a metric that is very important for both business and personal finances. It is a formula that is expressed as a percentage. This percentage is often used by lenders when applying for financing. It provides insight into the applicant’s debt management and their ability to repay a loan.

The DTI, as the debt-to-income ratio is also known, means that when the percentage is higher, the lender assesses it as a higher risk. For the borrower, a high ratio may mean worse terms for the financing, more expensive financing, or even no financing.

How is the debt-to-income ratio calculated?

DTI can be calculated in a variety of ways. Many accounting programs integrate this type of metric.

However, if you want to calculate it manually, it is also possible: you first need to add up all your monthly debts for the manual calculation. Within these debts, you should include rents, mortgages, student or personal loans, credit card payments, alimony, maintenance payments, etc.

The sum obtained for all debts must be divided by the gross monthly income. To obtain the percentage, the result of this division is multiplied by 100:

Monthly debt/Monthly income= X x 100= DTI

For example: let’s say your monthly debt is $2000 and your gross monthly income is $4000:

2000/4000= 0.5×100= 50%

As you can see, in this case, the DTI would be 50%. That is, as we will see later, a very high percentage.

So, in summary, to get the DTI:

  • Add up all your financial debts.
  • Divide the sum by your gross income
  • Multiply the result by 100 to get your percentage

It is important to note that this calculation does not include other monthly expenses and financial obligations. For example, food expenses, utilities, health care, or school expenses.

What makes up the debt-to-income ratio?

Especially when it comes to credit appraisal, mortgage lenders will use two different components: the initial and the final ratio.

The initial ratio refers to the percentage of gross monthly income allocated to housing expenses. All expenses include mortgage payments, taxes, insurance, or homeowner’s association fees.

The final ratio refers to all income needed to meet monthly debt obligations, including mortgage and housing costs. As we have seen, this includes credit cards, financing for vehicles, personal finance, etc.

How does the DTI affect your finances?

That could also apply to companies. However, companies usually have the whole process automated. It is interesting to focus on what it means for individuals as it can easily extrapolate to companies.

It usually goes to 28% as the ideal percentage for the initial relationship. Remember that this was the one that referred to housing costs.

On the other hand, a maximum of 36% will be considered an acceptable amount for the final ratio.

You should not think, in any case, that this will mean that you will not be granted a loan if you exceed these percentages. Other factors such as your credit score, property, savings, etc., will play a role here.

Is the credit score affected?

The credit bureaus do not look at income when doing credit reports. That means that your DTI will not directly affect your credit score, but it can indirectly.

You probably also have a high credit usage ratio if you have a high-income-to-debt one. That is considered at least 30% of your credit score.

Credit utilization ratios relate to the balances you have outstanding on your credit concerning your credit limits. For example, a credit card with a limit of $4,000, if you have a great balance of $2,000, has a credit utilization ratio of 50%.

When seeking mortgage financing, it is generally not recommended that credit utilization rates be above 30%. It is always a good idea to reduce the DTI ratio and improve the credit utilization ratio.

How do you manage the relationship between income and debts?

There are many formulas for both personal and business finances to improve the relationship between income and financial debts.

However, there are at least three aspects of improvement that you should take into account. All these areas of improvement always consider an initial factor: the need to create budgets to manage your finances.

The first aspect would be to have a clear plan for debt repayment. Numerous formats allow you to deal with debts in a more or less simple way, from the more aggressive methods such as the avalanche method to the slower ones such as the snowball method.

The second aspect would be to improve the conditions of your financial debt. We have contracted financial products that have become obsolete in the market on many occasions. If they are expensive or have high-interest rates, we should try to negotiate these debts. Sometimes it may even be more interesting to consolidate the debt through debt consolidation.

Finally, a crucial aspect is not to take on more debt. Please do not take on more credit, increasing the DTI index and worsening the credit score.