Debt-to-Income Ratio: The Complete Guide

Your Debt-to-Income Ratio is a critical number that you should always be able to estimate, not only in advance of a loan application where it will be used, but to give you insight into your risk of having too much debt or being in danger of defaulting on future credit lines and loans.

What is a Debt-to-Income Ratio?

Your debt-to-income ratio (DTI) quickly demonstrates how much debt you have when compared to your income. It is a quick and relatively easy formula to determine if you have too much debt (“over-leveraged”) or can likely afford another loan. To calculate your debt-to-income ratio, divide your monthly gross income by your monthly minimum debt payments.

The most basic DTI formula looks like this:

Debt-to-Income-Ratio-Equation.png

Understanding Your Debt-to-Income Ratio and Its Importance in Your Finances

When you apply for a home loan, car loan, or consumer loan, the lender will almost certainly include among his or her calculations your Debt-to-Income Ratio, or DTI, in one form or another. Since lenders are most interested in lending to borrowers who they have confidence will repay the loan as agreed, lenders want to avoid approving a loan that will overburden the borrower. The DTI is a powerful and proven tool in this process.

Deciding upon a borrower’s “creditworthiness” is a matter of predicting future behavior. Since recent past behavior is the best predictor of future behavior, lenders will look at your current and recent debt and income behaviors in order to predict how you will repay your future obligations to them. Even if you completely expect to get a raise, start a side job, or receive a cash gift, lenders are not interested since these are all still just possibilities. They want cold, hard facts. When money counts, decisions are made on current realities.

The debt-to-income ratio is so widely used among lenders because it is a relatively easy formula to calculate and gives a reliable picture of the consumer’s current state of financial affairs, particularly with regards to debt. The most basic reality lenders want to discover is whether the potential borrower can both afford to repay any new loan while also demonstrating the discipline to do so.

The DTI addresses just the first of these two realities. If the consumer carries debt equal to or greater than 35% or 40% of his or her income, the reality in most cases is that he or she will struggle to repay those debts while also needing to purchase groceries, pay utilities, afford insurance, maintain transportation, and secure the other necessities and priority wants of life.

The consumer’s credit rating, or credit score, predicts the consumer’s second reality: that of demonstrating the required discipline to pay as agreed, regardless of ability. Consequently, the consumer’s DTI and credit rating form the basis of a large percentage of loan application decisions each year. In fact, many loan officers often give preliminary, unofficial verbal denials of loans to borrowers as soon as they see a DTI that surpasses acceptable levels.

How Many Debt-to-Income Ratios Are There?

There are two basic DTI ratios, the “Front-end” ratio and the “Back-end” ratio. Each is used for different purposes by different professionals.

Front-end Debt-to-Income Ratio

The front-end DTI ratio has two versions of its own as well: your current front-end DTI and your projected front-end DTI. Both front-end DTI ratios focus only on your monthly housing costs. These housing expenses include your monthly mortgage or rent payments, your homeowner’s insurance monthly premium, your property taxes (annual taxes ÷ 12), your monthly private mortgage insurance (if you have it), and any monthly homeowner’s association dues (or annual dues divided by 12) you might have.

Your projected front-end debt-to-income ratio, on the other hand, includes the estimated mortgage payment, any homeowner’s insurance monthly premium you might be required to pay, your estimated monthly property taxes and any corresponding monthly homeowner’s association dues.

The current front-end DTI is mostly for educational and informational purposes. You should regularly consider your current front-end DTI to determine if too much of your income is going toward servicing your housing-related debts. Anything in the 30% range is high, though not unmanageable. The lower your current front-end DTI, the better.

If your current front-end DTI is in the 40% or higher range, you are likely headed for some significant financial difficulties and should immediately consider a plan to reduce your debt balances.

Back-end Debt-to-Income Ratio

The back-end DTI starts with the same expenses and debt included in the front-end DTI and adds all other debts. The Back-end DTI ratio gives a much more complete and well-rounded picture of the consumer’s debt obligations compared to his or her income. Besides home-related expenses, the bank-end DTI also includes the consumer’s following monthly payments:

  • Car or Truck Loan Payments

  • Credit Card Minimum Payments (Typically 3% to 5% of Your Current Balance)

  • Home Equity Payments

  • IRS Income Tax Account Approved Repayment Plan (Delinquent Tax Debt)

  • Payment Due for Over-Drafted Account

  • Personal or Signature Loan Payments

  • Personally-Guaranteed Business Loan Payments

  • Retail Account Payments (e.g. Computer, Appliance or Furniture)

  • Store Card Payments (Calculated Similarly to Credit Cards)

  • Student Loan Payments (Current or Upcoming if Exiting Deferral within a Year)

  • Child Support Payments

  • Alimony Payments

  • Monthly Payment Arrangements for Collection Accounts

  • Any Other Monthly Debt Obligations* (Whether Found on the Consumer’s Credit Report or Not)

*For example, while a debt to a doctor’s office or a loan from a family member will not be on your credit report, your calculated DTI will be inaccurate if you do not include these monthly payments among your debts. While many consumers do not want to disclose unreported debts, the reality is that if you withhold the information, you are giving an inaccurate version of your debt-to-income ratio, likely leading to troubles for both you and the lender.

What Monthly Obligations Are NOT Included in Your Debt-to-Income Ratio?

There are several monthly obligations included in the debt portion of your DTI that are not technically debts. These include homeowner’s insurance, private mortgage insurance premiums, and homeowner’s association dues, child support payments and alimony payments.

This begs the question as to whether all monthly obligations are included in the debt-to-income ratio. The simple answer is no. Contractual, non-debt obligations are generally not included in your DTI, such as:

  • Car/Truck Insurance Premium

  • Cell Phone or Home Phone Bill

  • Childcare Costs

  • Electricity Bill

  • Gym Membership Fee

  • Health Insurance Premium

  • Heating Bill

  • House Cleaning Contract Payment

  • Internet, Cable/Satellite TV Bill

  • Landscaper Contract Fee

  • Life Insurance Premium

  • Music Subscription

  • Premium TV or Movie Channel Subscription (e.g. Netflix, Hulu)

  • Storage Unit Payment

  • Income Tax

  • Water-Sewer-Trash Bill

The thinking here is that these services and products will be paid by the borrower using the rest of the borrower’s income not being used to service the debt in his or her debt-to-income ratio.

What Income Is Included in Your Debt-to-Income Ratio?

The second portion of the DTI involves your income. Lenders want to see solid, reliable, regular income if they are going to use it to predict whether you can afford your future monthly payments on a new loan. Consequently, the most common forms of monthly income included in your DTI are:

  • Alimony Received

  • Child Support Received

  • Gross Income (whether hourly wages or monthly salaries)

  • Lottery Winnings Annuities (paid annually and averaged monthly)

  • Pension Income

  • Rental Property Income if in Your Name

  • Second Job or Side Gig Income

  • Self-Employment Income

  • Social Security Disability Insurance

  • Social Security Retirement Income

  • Social Security Survivor Benefits

  • Supplemental Security Income (SSI through Social Security Administration)

  • Tips and Bonuses

Lenders are looking for income that the borrower can count on receiving throughout the life of the debt repayment term.

What Income Is NOT Included in Your Debt-to-Income Ratio?

Lenders generally disregard temporary, sporadic, unreliable or unpredictable income. Since they are lending real money, lenders want to use real (i.e. reliably regular) income for the basis of their decisions. Consequently, most lenders will exclude the following sources of income when calculating a potential borrower’s debt-to-income ratio:

  • Babysitting, Lawn-mowing, or Other Informal Income

  • Business Gross Income

  • Cash Gifts from Family, Friends or Others

  • Loan Payment from Family or Friends

  • One-time gambling winnings (slot, table, etc.)

  • Parent’s or Sibling’s Income

  • Spouse’s Income (unless Applying for a Joint Account)

  • Tax Refund whether local, state, or federal

  • Value of Investment Account

If you wonder about a certain income being counted in your debt-to-income ratio, ask whether the IRS is aware of the income. Then, is the income in your own name? Is it income you receive regularly, usually in the same amount each month? If you can answer “yes” to each question, then it might be counted. That said, answering no does not necessarily exclude the income from being included in your DTI.

What to Do if Your Debt-to-Income Ratio Is Too High

Whether you figure out your debt-to-income ratio using our DTI calculator, or you have been told by a potential lender that your DTI is too high for consideration of a loan, you might consider the following ideas for improving your financial situation. You should look at these ideas whether you plan to re-apply for the potential loan or not.

Time to Plan and Control Your Spending

First, while your high debt-to-income ratio is likely a result of various choices and events, it is definitely telling you to plan your spending and to minimize overspending and overborrowing. Except in cases of extensive medical debts from unpreventable accidents or health conditions, most cases of overwhelming debts can at least be minimized if not prevented by developing a few basic financial habits. These include the centrally important habit of paying yourself first every time. By placing some amount of every paycheck, every gift, and every income source into an emergency savings fund, you will be in a better financial place to address even such difficult situations as temporary periods of unemployment, severe medical issues, being widowed, or even going through a divorce. With your habit of savings set, your spending plan becomes a simple process of matching your income to your monthly needs and wants.

Set up auto-payments to your debts, identify how much you will need for groceries, gasoline, utilities, cell phone, etc., and you have the framework of a functional and helpful budget.

Demonstrate and Put into Practice a High Level of Productive Patience

Next, be patient. If you figured out your own DTI and noticed it is above the lender’s acceptable levels, now may not be the time to apply for the loan you are seeking. Although applying for a loan that is rejected will not have any effect on your debt-to-income ratio, it might have a small negative effect on your credit rating. In addition to your DTI, your credit rating is a major deciding factor your potential lender will consider.

Patience does not mean doing nothing quietly. Your patience can include a laser focus on addressing issues within your personal and household finances that might be contributing to your high DTI. Plan your spending, put large purchases such as a new car or new appliance on hold or at least on a plan to save up and purchase without additional debt, and look for ways to improve your DTI.

Debt-to-Income Ratio Explained

When it comes to improving your DTI, you have three options and only three options to consider:

  1. Increase your income

  2. Lower your debts and financial obligations

  3. Do a combination of #1 and #2

Increasing Your Income

By increasing your income, you increase the denominator of the DTI formula, making the ratio smaller. The more you increase your income, the faster your ratio will fall.

When considering how to increase your income, keep in mind the two lists above dealing with incomes that ARE included in the DTI and incomes that AREN’T included. Focus on incomes that ARE included.

We will NEVER recommend you play the lottery, so please disregard that entry. However, can you work a side gig for a month or two or three to establish a pattern of increased income? Whether you are delivering food, freelancing as a writer, or taking yard sale deals you find retailing them on Amazon, a side gig with the most likely and commonsense way to build your income. You might even turn babysitting money into a regular gig by looking into daycare options in your home. Side gigs, though, come with obvious and not-so-obvious drawbacks. They demand a significant amount of time to work, often 4-6 hours a day after a shift at your first job each day.

Some, like food deliveries and ride sharing, take additional tolls on your vehicle by putting extra mileage and requiring additional gasoline expenses. Take such extra costs into account when looking to increase your income. However, steer clear of the rationalization to avoid jobs that make minimal income below what your time is worth financially.

Your time is not reimbursable outside hourly or salaried positions, so any extra income earned is above and beyond your current income. That said, your time is valuable in other ways, however you choose to spend it and with whomever you choose to spend it.

Of course, you can always ask for a raise, recommend a bonus tied to your work and even investigate automating child support or alimony to increase its likelihood of arriving on time and in full each month.

Lowering Your Debts and Financial Obligations

To accelerate your debt repayment and consequently lowering you DTI ratio, there are only four effective options to consider:

  1. Repay the debts on your own using one of the four methods we describe in our DIY section.

  2. Work directly with your creditors to lower your interest rates.

This is most commonly effective with credit card and store card accounts. If you have a credit card with a 29% interest rate and yet you have made payment on time for the past year or more, call the card’s customer service department and explain how you are less of a risk now than you were a year or two ago, having proved so by making on time payments for a year. If they refuse to lower your rate, let them know you will be transferring your balance to a different card company, although you would prefer not to. In most cases, credit card companies would rather lose out on a small portion of the interest you pay by lowering your rate than the entire amount of the interest you would pay by having it paid off by a balance transfer.

Once you secure a lower interest rate, continue to make your current monthly payments, even if the credit card company asks for less each month. Sending even $50 extra a month to a $5,000 credit card balance can accelerate your pay off from 15 years down to 3 years or less.

3.      Work with Credit Counseling Agency (CRA) like Money Fit. The CRA works with your current creditors to lower your interest rates, waive late or over-limit fees, typically leading to lower monthly payments and a debt freedom day just five years or less in the future. There are no prepayment penalties, and there is no reason you can’t send extra payments through the CRA to accelerate your repayment plan even more.

4.      Negotiating the principle balances on your accounts may seem like a godsend, but beware of the dangers it will pose. Not only are debt negotiation companies (aka debt settlement companies) successful in less than 15% of cases, the methods they follow usually lead to even greater damage to your credit rating. This will likely prohibit you from qualifying for your next loan.

5.      Bankruptcy exists for a reason: to protect your assets from creditors when you are unable to pay your obligations. If a bankruptcy is your best option, then qualifying for a loan had better be your lowest priority. A bankruptcy on your credit report is the single most damaging line item to your credit score, lowering it as much as 35%. However, bankruptcy is an effective way to get rid of your debt obligations. Just don’t expect potential lenders to look favorably upon your finances if they see a bankruptcy on your record from the past seven to ten years.

What Else to Consider Besides your Debt-to-Income Ratio

Focusing on your debt-to-income ratio is only one of your priorities when applying for a loan.  Consider the following questions before even heading to the bank or credit union or applying online.

Can You Afford Another Monthly Payment?

You will need to have a spending plan in place, knowing what your monthly income and expenses are, before you can determine the size of any monthly payment you can afford. With all your other monthly living expenses, debt payments and other obligations, what effect will a new monthly debt payment have on your finances?

  • Will you be unable to save anything at all? If so, you probably should not get the loan.

  • Will you be less like to afford your rent or mortgage? You should probably avoid the loan application

  • Will you have a hard time paying for your other financial priorities? You should probably reconsider talking to a lender.

Between 60% and 80% of households are already living paycheck-to-paycheck. Adding another monthly payment to your monthly expenses may be the breaking point leading to payment defaults on your other loans and accounts.

Can You Afford a Down Payment?

It is a common complaint heard from potential borrowers denied a low because they did not have a large enough down payment (e.g. on a car or home)? “If I could afford the down payment, would I be asking you for a loan?”

The reality, though, is borrowers who put a little of their own “skin in the game,” so to speak, are much more motivated to repay their debts and pay as agreed. Whether it’s 10% or 25%, any amount of down payment for the purchase of a home, car, truck, boat or RV will increase your chances of approval.

What is on your credit report?

When was the last time you looked at your credit report? If it has been more than a few months, head on over to the federally-mandated site at AnnualCreditReport.com to pull one, two or all three of your credit reports. You won’t find your credit rating (aka score) there, but you will see all the lines of credit and loans you have had in the past seven to ten years.

The Consumer Reporting Agencies (CRAs) generally group “potentially negative accounts” together so you can see what might be hurting your credit. Often, it will be a missed or late payment, especially if it occurred in the past one to two years.

For others, the negative effect on your credit rating comes from high account balances on your credit cards, store and retail accounts and car and home loans. Pay those down as much and as quickly as possible.

Besides lowering your DTI, work on improving your credit score by cleaning up your credit report. If there are errors or inaccuracies on your report, go directly to the home pages of Equifax.com, Experian.com, and TransUnion.com to dispute them. It may take 30 days, but in the end, removing inaccurate items will generally build your credit rating in the eyes of potential lenders.

What is your credit rating?

Your credit rating is based upon your history of monthly payments (on-time and as agreed is best while late or missing payments hurt significantly), your low balances when compared to your credit limits (your debt-to-limit ratio, often confused with your DTI), and how long you have had credit, among other factors. It attempts to predict your future loan payment behavior based upon your recent loan payment history.

The higher your credit score, in many cases, the higher DTI a lender will consider acceptable.

Related Questions

What are the guidelines on acceptable debt-to-income ratios used by Federal Housing Authority (FHA)?

While the Department of Housing and Urban Development (HUD) is the highest government body responsible for a healthy and growing housing market in the US, the FHA insures loans by approved lenders and sets minimum standards for such loans. Although its guidelines indicate a cap of 43% to 50% DTIs on loans it ensures, FHA insured more than half of its loans in 2018 and 2019 for borrowers with DTIs greater than 50%.

What debt-to-income ratio range does a car loan lender look for?

Automobile lenders want to see your projected DTI at 36% or less. Some lenders may go as high as 40% but above 40%, you will have a hard time finding a lender. To combat a high DTI, consider putting more money down or paying down or off a small loan.

Does my DTI matter after getting approved for a mortgage?

If you have been approved for a home loan, you will want to avoid anything that might negatively affect your DTI before the loan closes at the title company. Otherwise, the approval can be withdrawn, leaving you without a home to move into.