Debt To Income Ratio Definition

You are free to use this image on you website, templates, etc., Please provide us with an attribution linkHow to Provide Attribution?Article Link to be HyperlinkedFor eg:Source: Debt to Income Ratio (DTI) (wallstreetmojo.com)

A good balance between the debts to handle and the gross incomeGross IncomeThe difference between revenue and cost of goods sold is gross income, which is a profit margin made by a corporation from its operating activities. It is the amount of money an entity makes before paying non-operating expenses like interest, rent, and electricity.read more assesses a borrower’s ability to make loan repaymentsLoan RepaymentsA loan repayment calculator helps in determining the amount of each installment payable by the borrower on taking a certain amount as a loan at a specific interest rate to be repaid in periodic installments for a particular tenure.read more. The DTI ratio is a key factor for lenders to consider before approving a mortgage loan application. If the debt to income ratio calculation results in a lower figure, it assures lenders of receiving timely installments from the borrowers.

Debt To Income Ratio Explained

A debt to income (DTI) ratio is obtained when the monthly dues, debtsDebtsDebt is the practice of borrowing a tangible item, primarily money by an individual, business, or government, from another person, financial institution, or state.read more, and liabilitiesLiabilitiesLiability is a financial obligation as a result of any past event which is a legal binding. Settling of a liability requires an outflow of an economic resource mostly money, and these are shown in the balance of the company.read more are divided by the gross monthly income of an individual or organization. The market lenders use the resulting figure as a parameter to judge if they should approve or disapprove a loan application. 

Key Takeaways

  • The debt to income (DTI) ratio specifies the portion of the gross monthly income dedicated to borrowers’ financial obligations.DTI ratio is a key factor that lenders calculate to assess how capable a borrower is of repaying the loan easily.The front-end ratio (monthly financial liabilities) and back-end ratio (recurring payments including front-end liabilities) are the two types of DTI ratios.Maintaining a good DTI ratio balance is a must for borrowers to get their further loan applications approved without much struggle.

If the ratio obtained is higher than expected, the banks and financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more do not agree to offer finances in such a scenario. A higher DTI ratio indicates the debts and liabilities are considerably higher, and another loan would be difficult to manage for a borrower. On the other hand, when the debt to income ratio for mortgage is low, lenders know they will receive payments on time.

The DTI ratios are of two kinds – front-end ratios and back-end ratios. The front-end ratios include the portion of the gross monthly income used for repaying mortgage installments, rent, property taxes, insurance, etc. On the contrary, the back-end ratios mark all recurring payments that borrowers are liable to pay, including those under the front-end ratios category.

Uses

When borrowers apply for a loan of any kind, the first thing that lenders check is the DTI ratio. Maintaining a good debt to income ratio balance is a must as it builds their trustworthiness. As a result, the lenders approve their loan applications as and when they apply. For example, if the DTI ratio is 10%, it implies that the borrower pays that percentage of the gross monthly income for debts and other liabilities. 

Normally, lenders approve loan applications with a DTI ratio of 43% to the maximum. However, borrowers must keep this percentage as low as possible for lenders to trust their ability to repay on time.

DTI Ratio Formula

The debt to income ratio formula is as follows:

DTI = (Total monthly debt payments)/(Gross Monthly Income)

Where,

  • The total monthly debt payments include the sum of all the financial obligations borrowers have for a month.The gross monthly income is the total earnings Earnings Earnings are usually defined as the net income of the company obtained after reducing the cost of sales, operating expenses, interest, and taxes from all the sales revenue for a specific time period. In the case of an individual, it comprises wages or salaries or other payments.read moreof the borrowers for a month.

Debt to Income Ratio Calculation

Let us explore the following DTI ratio example below to understand the concept and calculation:

David applies for a credit card for smaller purchases. The credit card company asks him to provide his proof of income. It finds that David earns around $10,000 per month. Thus, the company calculates the ratio to check if it fulfills the company’s repayment terms.

The company also asks for details about the other debts that David has to pay. It comes to know that the credit card seeker has a mortgage loan of $2,000 and a car loan of $1,000 to pay every month. Based on the information, it calculates the DTI ratio:

   = (2000 + 1000) / (1000) = 3000/1000 = 30%

David’s credit card application gets approved as he fulfills the company’s repayment terms.

How To Improve DTI Ratio?

The DTI ratio calculation considers all financial obligations equally, irrespective of the factors influencing repayment behaviors. For example, the repayment terms for student loans and credit card payments are different. The former is available at lower interest ratesInterest RatesAn interest rate formula is used to calculate loan repayment amounts as well as interest earned on fixed deposits, mutual funds, and other investments. It is also used to calculate credit card interest.read more, while the latter is at a higher interest rate. However, they are all considered equal while making DTI ratio calculations. 

Thus, borrowers should maintain proper repayment behavior. In addition, it lets lenders trust them for approval of their future loan applications. It, in turn, will keep their DTI ratio balanced. Let us look at some of the ways of improving the DTI ratio:

  • The borrowers should avoid purchasing unnecessary products. Spending unnecessarily increases their financial obligation, restricting them from delaying buying the required things.Borrowers can increase their monthly installment amount for their loans. It might seem to raise the DTI ratio for that period but will greatly help in the long run as the DTI ratio gets reduced to a significant extent.Try not to involve in too many loans or financial obligations.Keep monitoring the DTI ratios every month and track if the finances are handled well. If the output is unsatisfactory, implement relevant measures to take control of the situation.

Video on Debt to Income Ratio Formula

This is a guide to the Debt to Income Ratio (DTI) & its Definition. Here we explain what is good DTI, how to calculate it for mortgage loans & its formula. You may also have a look at these articles below to learn more about Financial Analysis –

The DTI ratio involves calculating the portion of the gross monthly income that borrowers have to keep aside for repaying their total monthly debt. Finding out the DTI ratio helps lenders receive timely installments from respective loan seekers. The lenders approve or disapprove of a loan application based on their repayment capability.

The DTI ratio is calculated by dividing the gross monthly debt/financial liabilities by the gross monthly income of the borrowers, be it an individual or an organization.DTI = (Total monthly debt payments)/(Gross Monthly Income)

The DTI ratio is expected to be as low as possible. However, as per the normal acceptance of the lending institutions, it has been observed that the ratio of up to 43% is considerable. Anything above that is not acceptable. The lower DTI ratio signifies the higher capability of the borrower to repay on time. In short, the lower the ratio, the better it is for loan seekers.

  • Total Expense Ratio FormulaTotal Expense Ratio FormulaThe total expense ratio is the total investment cost to the investor who invests in a mutual fund, equity fund or exchange-traded fund. It included the transactional costs of investment, legal, management, auditor fees and many other miscellaneous operational expenses determining the final return on the investment.read moreDebt to GDP Ratio DefinitionDebt To GDP Ratio DefinitionThe debt to GDP ratio is a metric to compare a country’s debt to its GDP and measures its capability to repay its debt. A country with a high ratio would not have difficulty repaying its debt but will not seek debt due to higher chances of defaulting.read moreCalculate Debt to Asset RatioCalculate Debt To Asset RatioDebt to asset ratio is the ratio of the total debt of a company to the total assets of the company; this ratio represents the ability of a company to have the debt and also raise additional debt if necessary for the operations of the company. A company which has a total debt of $20 million out of $100 million total asset, has a ratio of 0.2read moreDebt Ratio Calculator