Debt to income ratio (DTI) is the debt ratio that used to assess the financial credibility and ability that entity or individual could pay off its debt by considering the relationship between recurring monthly debt over the gross monthly income.
Debt to income ratio is normally used by lenders, bankers, or creditors to assess prospective borrowers’ financial position who requesting a loan or some kind of credit.
Basically, if the ratio is equal to one, that means the prospective borrowers currently use all of their gross income to pay off the debt.
The formula used to calculate the debt to income ratio is very simple and easy. There are two important things that you need to know. First is monthly debt that needs to pay off, and second is monthly gross income.
Here is the formula to calculate Debt to income ratio:
Debt to Income Ratio : Recurring Monthly Debt / Gross Monthly Income
- Measurement: This ratio is measured as the percentage (%) or time
- Recurring monthly debt: This is the monthly debt that needs to be paid. For example, monthly payment to the car loan, monthly payment to mortgages, and another similar kind of debt or expenses.
- Gross monthly income: This is referred to as a total monthly income that earns. For example, monthly salary income, monthly sales income or similar kind.
Jame’s monthly payment to a loan for his new car amount 1,000 USD, installment for his new house 3,000 USD, and others debt amount 3,000 USD. Currently, Jame earns a monthly gross income amount of 8,000 USD. Calculate Jame’s DTI.
Based on the example above, we got
- Recurring monthly debt = 7,000USD (1,000USD + 3,000USD + 3,000USD)
- Monthly gross income = 8,000 USD ( provided)
Debt to income ratio = 7,000 / 8,000 = 0.875 or 88%
Debt to income ratio is one of the most important factors in the success of loan processing. If the ratio appears good, then the loan process is highly successful.
However, if you got the ratio around 48% or above, then the rate of success is quite impossible. In general, the lower the ratio you got, the better chance you have. The god ratio is below 20%, but the maximum ratio depending on creditor or bankers.
based on the calculation above, Jame got 88% of DTI and this rate is very difficult for him to get success on his loan processing. The bank might not allow him to get the loan. However, DTI is just the one factor to assess the possibility that Jame is able to pay back the loan to the bank.
If Jame could prove that his DTI ratio will very soon go better and he will be able to pay back all the debt as well and monthly payment, the bank might consider. For example, the pay for current monthly debt is going to pay off next month.
Let say, monthly payment for new car amount 1,000 USD, and installment for his new house 3,000 USD will end next month. That means the DTI will significantly decrease and the bank might consider the loan.