A business entity, either small or large, has a combination of capital sources. The two most common sources of capital financing are debt and equity. The external stakeholders want to analyze if the company will be able to pay back the debt on time.
Ratio analysis helps the stakeholders to analyze and compare different financial metrics of a business entity with objectivity. The debt ratios, in general, are leverage ratios that calculate the financial leverage of a business entity. These ratios compare debt to equity, assets, capital, and income. The debt ratios tell the creditors about the solvency of the company.
In the parallel world of personal finance, individuals also do transactions involving equity and debt. For assessing the individual’s ability to pay back the debt from his income sources or assets. The debt ratios are similar to the corporate financial ratios.
This article will focus on the debt-to-income ratio, its calculation, interpretation, examples, and importance for the individual and creditors.
What Is Debt-to-Income Ratio?
The debt-to-income ratio, parallel to the debt-to-Ebitda ratio, is a financial leverage ratio. We can define the debt-to-income ratio as,
“Debt-to-income ratio enables the creditors to assess an individual’s ability either it can pay back the debt payments from its recurring income. The creditors compare the annual or monthly debt payments of a company with the annual or monthly income of the individual”.
The creditor makes the comparison by dividing the monthly gross income by the monthly debt payment. The results help the creditor to decide if to lend money to an individual or not. It is very important in personal finance and works like a credit rating of an individual.
Front-End Vs. Back-End DTI Ratio
Two main ratios form the debt-to-income ratio:
When we talk about the front-end ratio, it is based on the expenses of an individual, like a mortgage, rent, hazard insurance, mortgage insurance, taxes, etc.
On the other hand, the back-end ratio is a more comprehensive debt-to-income ratio. It takes into accounts all the recurring debt payments, including the front-end items. Besides mortgage, insurances, and tax, the additional items include credit card bills, student or car loans, etc.
Formula for Calculating Debt-to-Income Ratio
The debt-to-income ratio is often pronounced as the DTI ratio. The gross income of an individual from all sources before taxes and other deductions is taken. It is compared with the monthly debt obligations due on the individual.
You can find the debt-to-income ratio by the following formula:
Debt-to-Income ratio = DTI = (Total of Monthly Debt Payments) / Gross Monthly Income (before taxes)
How to Calculate Debt to Income Ratio?
You can calculate the debt-to-income ratio or credit utilization ratio by using the formula above. You will sum up your income from all the sources. Add up the monthly debt payments, credit cards, mortgages, etc. After that, you will divide the debt amount by the monthly income to yield a debt-to-income ratio.
Let’s understand with an example.
Emile is a female photographer who provides freelance photography services. Her average monthly income is about 4,000 USD.
The income is reported before taxes and interests, gross income. She has a car loan, home loan, and credit card payment due. The monthly payment of her home loan is around 1,200 USD, the loan for the car amounts to 600 USD, and her credit card bills are 250 USD.
Emile’s debt-to-income ratio will be calculated by summing up the debt and dividing it by the gross income.
Total monthly debt payments = home loan + car loan + credit card bills
Total monthly debt payments = $(1,200 + 600 + 250)
Total monthly debt payments = 2,150 USD
Debt-to-Income ratio = DTI = (Total of Monthly Debt Payments) / Gross Monthly Income(before taxes)
Debt-to-income ratio = 2150/4000
Debt-to-income ratio = 0.5375 = 53.75%
The amount signifies that 53.75% of Emile’s gross income is spent on paying the debt. The remaining income is less than 50%, showing that Emile will be unable to pay new EMIs if applied.
What Does Constitute Your Debt-to-Income Ratio?
Interpretation Of Debt-to-Income Ratio
A higher debt-to-income signifies the inability of an individual to get future loans. The lower the DTI, the better it is. Lenders usually consider DTI when an individual applies for a loan. As a standard rule, if you have a DTI of more than 36%, your chances of getting a new loan diminishes with increasing DTI.
According to Well Fargo, most lenders view your debt-to-income ratio as follow:
35 percent or less
Less than 35% is viewed as a good DTI. 35% or less of your gross income will pay your monthly debt. If you want to apply for a new loan, you can manage the debt payments.
36 to 49% is not generally a good debt-to-income ratio, but lenders view it as an improvable ratio. You can improve your debt-to-income ratio by lowering your other debt payments. We can further segregate the category into two sub-categories: 36-43 percent and 44-50 percent.
36 to 43% signifies that you are managing debt, but the risk is increasing that it can become unmanageable in the future. It also shows that you can get approved for any type of loan. However, there is little room for flexibility; in other words, you must work to improve your debt-to-income ratio.
On the other hand, 44 percent to 50 percent DTI will qualify you for smaller loans, but it is already alarming. If you are looking for a mortgage, even 44% DTI means you will have a tough time qualifying for it.
50 percent or more
50% or above is an alarming debt-to-income ratio, and you are in a danger zone. You have hardly left with any emergency fund. If you have DTI above 50%, your borrowing limits exceed, and you will have no very limited borrowing options.
Importance of Debt-to-Income Ratio
The debt-to-income ratio is an important measure in personal finance. Whether you want to apply for a personal loan, mortgage, credit card loan, or buy insurance, your debt-to-income ratios significantly contribute to calculation.
When you are applying for a home mortgage, car loan, or personal loan, the lenders usually check your debt-to-income ratio to see if you qualify for the loan. Different empirical research and consumer reports of financial institutions have highlighted the direct relationship of a high DTI ratio with borrowers’ inability to make monthly debt payments.
However, the threshold for the DTI ratio set by different lenders varies. If we talk about the personal loan, the creditors and lenders usually do not publish the DTI ratio as a prerequisite of qualifying for the loan. Therefore, you can expect to borrow money from a few lenders even at a high DTI ratio of 50% or more. However, the interest rate will be high for that.
Some lenders also exclude the amount of mortgage for personal loans, further lowering the DTI ratio.
Unlike the lenient policy of lenders, the financial institutions and mortgage lenders have very clear and loud DTI ratios as a criterion of qualification. In most cases, mortgage lenders usually accept a 43% DTI ratio as the upper limit. If you have DTI below 43%, the chances are minimum for you to get a loan.
For Your Credit Ratings
Many people ask if the DTI ratio contributes to the calculation of the credit ratings of an individual. So there is good news. Your DTI ratios are not a contributing factor in the calculation of credit scores. Credit rating agencies might ask about your income, but they usually do not factor in calculating the credit scores.
However, the credit-utilization ratio considers your DTI ratio. Credit utilization measures how efficiently you are using your credit as compared to your credit limits. On the other hand, credit utilization ratios matter when the companies are calculating your credit score.
You can reduce the DTI income by increasing your income or decreasing your debt.
Tips to Lower Your Debt-to-Income Ratio
Higher debt-to-income negatively affects your financial health. Therefore, correcting it to have better financial health is necessary. Here are some tips on how you can lower your debt-to-income ratio:
- By increasing your monthly payments toward debt, you can pay your debt earlier. Once your debt level is lowered, your DTI will improve automatically.
- Another way to control your DTI is not to take more debt. By doing so, your DTI will remain the same.
- If you make large purchases on credit means worsened DTI ratio. If you postpone your large purchases for a few months, you can save a handsome amount of funds for the down payment. Consequently, your credit limits will not exceed, and DTI will be lower.
- Keep track of your DTI by calculating it every month with your income and debt payment. Doing so will help you manage DTI very well. You can track if DTI is exceeding and take corrective actions instantly.
In a nutshell, DTI is an important measure in your debt ratios. Therefore, understanding its calculation, constitution, and tips to lower DTI is very important. This article will help you clear all the ambiguities about DTI and its importance in your overall financial health and financial leverage ability.