Debt to income ratio is a personal finance measure that seeks to compare the amount of consumers’ monthly income that goes towards the payment of debts, taxes, and fees or insurance premiums. Lenders rely on this metric to ascertain whether borrowers would be able to repay an amount they wish to borrow.
Debt To Net Income Calculation
Debt to net income ratio is calculated by simply adding up all monthly debt payments and dividing by total income before taxes.
Studies have shown that people with higher debt to earnings ratios are more likely to run into trouble. This is partly because a higher ratio signals an increase in debt levels relative to earnings. In the U.S, 43% is the highest DTI ratio that one can have and still be considered for a mortgage.
However, most lenders prefer a DTI ratio of less than 36%, as it indicates the ability to pay debt back various debts. A low debt to income ratio of less than 15% signals a good balance between overall debt and income. Financial institutions prefer people with low DTIs when issuing loans. However, the exact DTI preference varies from one lender to another.
A debt to income ratio of 15% indicates that only 15% of a consumer’s gross income goes towards the repayment of underlying debts. In this case, a consumer would be in a good position to manage monthly debt payments as well as add a new one.
Types of Debt to Income Ratio
Front-end ratio is a type of debt to income ratio that indicates the amount of income that goes towards the payment of housing costs such as a mortgage and other expenses tied to housing.
The second type of DTI ratio is known as back-end ratio. It indicates the amount of a consumer’s gross income that goes towards the repayment of recurring debts. Some of the debts covered on this front include credit card payments, car loans, student loans, and child support.
How To Lower Debt to Income Ratio
Lowering debt to income ratio is very much possible. Start by reducing your recurring monthly debt. In addition, increasing gross monthly incom, by pursuing other avenues of income can also go a long way in lowering the DTI ratio.
Debt To Income Ratio Limitation
Debt to income ratio is not the only financial metric that lenders look at before issuing credit. A borrower’s credit history as well as credit score are some of the most-watched financial metrics before the approval of any credit line.
One of the biggest limitations of debt to income ratio is the fact that it does not distinguish between the different types of debt and the costs of servicing them. The metric lumps all debts together even though some debts come with higher servicing costs. For this reason, debt to income ratio is simply one of the many metrics that lenders use to make credit decisions.