Definition

A debt-to-income ratio, also known as DTI, is a measure of the ability of a business or a borrower to pay back their debts. This ratio measures the monthly debt payments of a business or borrower against its monthly gross income.

In this case, the monthly debt payment comprises monthly bills such as rent/mortgage, car insurance, medical bills, health insurance, student loan, and credit card payments. On the other hand, the gross income will comprise the total monthly payment of a business or a person before taxes, or any other deductions are made.

Therefore, the debt-to-income ratio will measure how much of the gross income (that is, without any other deductions) goes into servicing the debts during a month. This measures the ability of the individual or an organization to pay off its debts by quantifying the rate at which the individual or the organization pays off its debts during a month from their income for the said month.

Additionally, there are two main forms of debt-to-income ratio:

1. Front-end ratio: the percentage of income that goes into paying off rent, mortgages, property taxes, and mortgage insurance.

2. Back-end ratio: the percentage of income that goes into paying off recurring debt payments and any credit cards, student loans, car loans,s and child support payments.

Formula

The debt-to-income ratio or DTI is calculated by total monthly debts paid by the total gross income during the same month and then multiplying the result by 100 to convert the ratio into a percentage. This can be done by adding the total monthly debt payments such as rent/mortgage, all insurances including health or car, car loans, student loans, child support payments, and even medical bills to arrive at the total payments made towards any debts during the month.

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Further, it is required that all the income(s) are added to arrive at gross income, which must not include tax or any other deductions. This has been further shown below:

Debt to Income ratio= Total Monthly Debts Paid / Total monthly gross income

Example

An individual pays $1000 a month for their mortgage, $125 for car insurance, and $475 towards other bills and debts during a month. The individual earns a gross income of $4000 during a month. What would be the debt-to-income ratio for this individual?

The debt-to-income ratio will now be calculated by:

Total debt payments: 1000+125+475= $1600

Total gross income during a month: $4000

To calculate the debt to income:

$1600 / $4000= 0.4

To convert the ratio into percentage:

0.4 x 100= 40%

Interpretation

This result indicates that 40% of this individual’s total gross monthly pay currently goes towards servicing debts and paying them off. This seems to be a higher Debt to Income ratio as repaying debts take up 40% of the total monthly earnings. In such cases, when the debt-to-income ratio is already very high, lenders are skeptical about extending further credit.

Analysis

The debt-to-income ratio is an important metric for analyzing the debt servicing capability of the business or an individual. It essentially measures the ability of a borrower to manage debts and make a payment from their gross pay or income. This allows gauging if the current income is sufficient for the borrower to manage further debt payments.

A lender is likely to use the debt-to-income ratio to analyze lending risk to a particular individual or organization. A high DTI ratio shows that a significant part of the income goes towards debt servicing, while a low DT ratio shows that a lesser part of the income is used for debt servicing.

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While a low Debt to income ratio makes sense from the perspective of lenders as they would want to be sure of repayments when considering the borrower’s income and ability to make repayments, it does not guarantee a loan or credit to be extended as the DTI is a part of the credit evaluation process where the lender may use more than one metric. However, it is more likely that a person with a lower DTI ratio will be granted credit more easily and quickly than someone with a higher DTI ratio.

Generally, the highest debt to income ratio an individual can have and still qualify for a mortgage is 43%. However, lenders generally prefer a lower debt to income ratio of up to 36% and not more than 28% of the debt payments towards rents and mortgages. When the debt-to-income ratio is higher than 50%, it means that you do not have enough money to pay off any additional debts and will not have money available in case of any unforeseeable events.

As a general rule of thumb, the lower the debt-to-income ratio, the higher the chances are for credit approvals.

Ways to reduce Debt to Income Ratio

There are mainly two ways to reduce the DIT ratio. These include:

1. Reducing debt payments- this can be done by paying the principal debts for any of the past loans and which will reduce the monthly interest payments, for instance. 

2. Increase gross income- The other way is to increase the monthly gross income to lower the DIT ratio as any increases in the income will mean a greater ability to pay off debts.

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Limitations

While DTI is useful in measuring the extent of the income that goes towards servicing debts during a month, it does not differentiate between various types of debts and the costs associated with them. This is especially relevant when credit cards carry a higher interest rate than student loans but will be grouped under debts in a DIT ratio calculation.

Similarly, if an individual were to start using a lower interest credit card from a higher interest one, their debts would automatically decline, meaning that the DTI ratio will decline too. In contrast, the total outstanding debts will not change.