What Is Debt-to-Income Ratio and How Do You Calculate It?

How much of your monthly income is used to pay off debt? Intuitively, we might all agree that the lower that amount, the better off we feel. Sensibly, we understand that the less money we spend on debt, the more we have to spend on fun things like vacation, dining out, and entertainment, as well as essentials like food, healthcare, and retirement savings.

 
That everyday perspective shows what the debt-to-income ratio is all about. Understanding and managing your debt-to-income can help you when applying for credit cards and loans, and to better manage your overall finances.

 
Let me explain…

Debt-to-income ratio is a financial metric that shows the percentage of your monthly income that is used to pay debts – and reveals what percentage is available to pay any future debt. A simple example: If you earn $1,000 per month and pay out $400 per month for debt payments, you have a debt-to-income ratio of 40%. Finance experts view debt-to-income as a measure of your overall financial health, including your ability to pay back debts.

 
A lower debt-to-income ratio is considered more favorable, as everyone needs to pay for things like taxes, food, and utilities. A lower debt-to-income ratio can also help put you in a better position to pay off unexpected expenses, like a car repair.

Lenders use your debt-to-income ratio, together with credit scores and other factors, such as your payment history, to evaluate your creditworthiness.

A healthy debt-to-income ratio is important for two key reasons. First, lenders have specific debt-to-income guidelines for approving credit and setting your interest rate, and guidelines may differ from lender to lender. Second, minding your ratio can help you manage a more comfortable household budget.

  
Debt-to-income is not your credit score and it’s not your debt-to-credit ratio. Your credit score, while important, is based mostly on payment history and doesn’t take your income into account like debt-to-income does. Your debt-to-credit ratio, better known as your credit utilization rate, shows how much credit you’ve used out of all the credit that is available to you. Both are important, but not to be confused with debt-to-income, which ignores available credit.

The formula for your debt-to-income ratio is straightforward division, reflected as a percentage. The formula is simply DTI = Monthly Debt Payments/Gross Monthly Income.

 
Your Monthly Debt Payments amount is meant to represent your recurring, committed debt obligations, so it excludes things like groceries, gasoline, and utilities. To calculate it, add together your monthly payments for:

• Rent or mortgage (include taxes and homeowner insurance only if it is included in your monthly payment).
• Alimony or child support.
• Student, auto, and other loans.
• Credit cards (use the minimum payment for the calculation).

To calculate your Gross Monthly Income, add up your monthly income (before taxes and any other deductions) from all the following sources:

• Wages, salaries, tips, and bonuses.
• Pension.
• Social Security.
• Child support and alimony.
• Any other additional income.

(If only annual amounts are known for some income sources, simply divide that figure by 12 before totaling the sum.)

The resulting percentage is known as your “Back-End DTI,” which is considered the default because it is the most comprehensive. Sometimes, mortgage companies calculate another version, called “Front-End DTI,” using the same formula but excluding all except the housing costs in the monthly debt payment amount. Front-end DTI can help mortgage companies understand your housing cost as a percentage of your income.

A debt-to-income ratio of 36% or lower is considered good by most lenders, and will give you better odds of qualifying for a loan or credit card, and for obtaining lower interest rates.¹ The Consumer Financial Protection Bureau (CFPB) notes that borrowers with ratios greater than 43% are considered riskier by lenders because studies show a higher likelihood of default.²

Improving your ratio is simple to describe but challenging to do: reduce your monthly payments, increase your income, or both. You can reduce your monthly payments by paying down credit card balances, paying off loans, or consolidating debts for quicker payoff. To increase your income you might ask for a raise, work extra hours, change jobs, or take on a side hustle.