The debt-to-income (DTI) ratio is a metric used by creditors to determine the ability of a borrower to pay their debts and make interest payments. The DTI ratio compares an individual’s monthly debt payments to his or her monthly gross income. It is a key indicator that lenders use to measure an individual’s ability to repay monthly payments and accumulate additional debt.
Understanding the Debt-to-Income Ratio
The debt-to-income ratio is of utmost importance to creditors that are considering providing financing to an individual. A higher ratio is unfavorable for creditors to see, as it indicates that a higher proportion of an individual’s income goes towards monthly debt payments.
For example, a DTI ratio of 20% means that 20% of the individual’s monthly gross income is used to servicing monthly debt payments. The maximum acceptable DTI ratio varies depending on the lender. As a guideline, it is preferable to achieve a ratio that is lower than 36%.
Front-End vs. Back-End Ratios
There are two main forms of debt-to-income ratios:
1. Front-end ratio
The front-end ratio specifies the percentage of income that goes towards rent, mortgage payments, property taxes, hazard insurance, and mortgage insurance.
2. Back-end ratio
The back-end ratio specifies the percentage of income that goes towards all recurring debt payments (including the ones above). Additional payments are added, such as credit card, car loan, student loan, and child support payments.
Overall, the front-end ratio helps measure the portion of income that goes towards housing costs, while the back-end ratio measures the portion of income that goes towards all costs.
Debt-to-Income Ratio in the Credit Analysis Process
The debt-to-income ratio is used as part of the credit analysis process to determine the credit risk of an individual. It is important to note that, for example, an individual with a DTI ratio of 15% does not necessarily possess less credit risk than an individual with a DTI ratio of 25%.
The DTI ratio only forms part of the credit evaluation of an individual; a thorough credit analysis must be conducted to correctly determine the credit risk of an individual.
Formula for the Debt-to-Income Ratio
Monthly Debt Payments refer to monthly bills such as rent/mortgage, car insurance, health insurance, credit cards, student loans, medical bills, dental bills, car loans, child support payments, and other payments.
Gross Income is the income of an individual before tax and other deductions.
An individual currently pays $2,000 a month for their mortgage, $100 for car insurance, and $500 in other debts. If the monthly gross income of this individual is $4,500, what is the debt-to-income ratio?
DTI Ratio = ($2,000 + $100 + $500) / $4,500 x 100 = 57.78%
Methods to Decrease the Debt-to-Income Ratio
1. Decrease monthly debt payments
By minimizing the monthly debt payments, an individual can decrease their debt-to-income ratio. For example, in a student loan, an individual has the option of repaying their principal debt to reduce the amount of interest charged.
Consider an outstanding $50,000 student loan with a monthly interest rate of 1%. Scenario one involves an individual who is not repaying their principal debt, while scenario two involves an individual who has paid down $30,000 of their principal debt.
As illustrated above, as an individual pays down more of their principal debt, the monthly interest payments decrease.
2. Increase gross income
By increasing the gross income, an individual can decrease their debt-to-income ratio. The method is self-explanatory – due to the fact that the gross income is in the denominator of the ratio, an individual with a higher income would lower their debt-to-income ratio.
Consider two scenarios with a monthly debt payment of $1,500 each. However, the gross monthly income for scenario one is $3,000, while the gross monthly income for scenario two is $5,000. As such, the debt-to-income ratio would be as follows:
DTI Ratio (Scenario one) = $1,500 / $3,000 x 100 = 50%
DTI Ratio (Scenario two) = $1,500 / $5,000 x 100 = 30%
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant CFI resources below:
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