Debt to Income ratio (DTI) is a financial metric that measures the amount of debt an individual or business has relative to their income. It is an essential measure of economic health, as it helps lenders, investors, and individuals assess whether someone is taking on too much debt relative to their income.
What is Debt to Income Ratio?
The debt-to-income ratio is an individual or business’s total debt payments to their income. This is usually expressed as a percentage. For example, if an individual has a monthly income of Rs.5,000/- and monthly debt payments of Rs.2,000/-, their DTI would be 40% (Rs.2,000 / Rs.5,000 = 0.4 or 40%). A high DTI indicates that an individual has a high amount of debt relative to their income, while a low DTI suggests that an individual has a low amount of debt relative to their income.
How is the Debt to Income Ratio Calculated?
To calculate DTI, you need to know your total debt payments and your income. Total debt payments include all the money you owe to lenders or creditors, such as mortgage loan payments, car loan payments, credit card payments, and other types of loans. Income includes all your money from your job, business, or investments.
Once you have these two figures, you can calculate your DTI by dividing your total debt payments by your income and multiplying by 100 to get a percentage. For example, if your total debt payments are Rs.2,000/- per month and your monthly income is Rs.5,000/-, your DTI would be 40%:
Why is Debt to Income Ratio Important?
DTI is an important metric because it helps lenders, investors, and individuals determine whether someone can afford more debt. For example, when someone applies for a mortgage or a car loan, the lender will look at their DTI to determine whether they can afford to make the monthly payments. If the DTI is too high, the lender may reject the loan application or offer a loan with a higher interest rate.
DTI is also essential for individuals because it helps them understand their financial health. If your DTI is too high, it may mean that you are taking on too much debt relative to your income, and you may need to take steps to reduce your debt or increase your income.
Types of Debt to Income Ratio
There are two types of DTI: front-end DTI and back-end DTI.
Front-end DTI:
Front-end DTI is the ratio of an individual’s total housing payments to their income. This includes mortgage payments, property taxes, homeowner’s insurance, and other housing-related expenses. Lenders use front-end DTI to determine whether someone can afford a house.
To calculate front-end DTI, divide your total housing payments by your income and multiply by 100 to get a percentage. For example, if your total housing payments are Rs.1,500/- per month and your monthly income is Rs.5,000/-, your front-end DTI would be 30%:
Back-end DTI:
Back-end DTI is the ratio of an individual’s total debt payments to their income. This includes all debt payments such as mortgage loans, car loans, credit card debt, personal loans, and other debt-related payments. Lenders use back-end DTI to determine whether someone can afford the additional debt.
To calculate back-end DTI, divide your total debt payments by your income and multiply by 100 to get a percentage. For example, if your total debt payments are Rs.2,000/- per month and your monthly income is Rs.5,000/-, your back-end DTI would be 40%:
What is a Good Debt-to-Income Ratio?
A good DTI ratio varies depending on the type of loan or credit being applied for. However, as a general rule of thumb, a DTI of 36% or less is considered a good ratio. This means an individual’s debt payments are less than 36% of their income.
For example, if an individual has a monthly income of Rs.5,000/-, their total monthly debt payments should be no more than Rs.1,800/- to have a DTI of 36% or less.
It is necessary to note that some lenders may have different DTI requirements based on the type of loan being applied for, and some loans may have higher DTI requirements than others.
Importance of Debt to Income Ratio for Lenders:
DTI is an important metric for lenders because it is unable to assess the risk of lending money to someone. If someone has a high DTI, it may indicate a high amount of debt relative to their income, making it challenging to make their monthly loan payments. This can increase the probability that a loan would default, which is a risk for the lender.
For this reason, lenders will often have DTI requirements for loans. For example, a lender may require a DTI of 43% or less for a mortgage loan. This means that an individual’s total debt payments, including their mortgage payment, should be at most 43% of their income.
Importance of Debt to Income Ratio for Individuals:
DTI is an essential metric for individuals because it helps them understand their financial health. If your DTI is high, it may indicate that you need to take on more debt relative to your income, which could lead to financial stress and difficulty in making monthly payments. This could also make it more challenging to qualify for loans or credit.
By understanding your DTI, you can improve your financial health. This may include paying down debt, increasing your income, or reducing expenses.
Example of How DTI is Used:
Suppose that Mr. A has a monthly income of Rs.5,000/- and has the following monthly debt payments:
- Mortgage loan payment: Rs.1,200/-
- Car loan payment: Rs.400/-
- Credit card payment: Rs.200/-
- Personal loan payment: Rs.100/-
To calculate Mr. A’s DTI, we need to add up his total monthly debt payments and divide them by his income:
Total monthly debt payments
Mr. A’s DTI is 38%, slightly higher than the recommended DTI of 36%.
This means that Mr. A uses more of his income to make his monthly debt payments, which could concern lenders.
If Mr. A were to apply for a mortgage loan with a lender with a DTI requirement of 43% or less, his DTI of 38% would meet the requirement. However, if Mr. A were to apply for a personal loan or credit card with a lender that has a lower DTI requirement, his DTI may need to be lowered for approval.
Mr. A wants to improve his DTI; he could take steps to pay down his debt, increase his income, or reduce his expenses. For example, he could consider refinancing his mortgage to lower his monthly payment or paying off his credit card debt to reduce his monthly debt payments.
In general, having a low DTI can make it easier to qualify for loans and credit and help individuals avoid financial stress and difficulty making monthly payments.
Limitations of Debt to Income Ratio:
While DTI is a valuable metric for assessing an individual’s financial health and risk for lenders, it does have some limitations. For example, DTI does not consider an individual’s credit score, assets, or other financial factors that may impact their ability to make monthly debt payments.
Additionally, DTI does not differentiate between types of debt. For example, a mortgage payment may be seen as “good debt” because it is an investment in a property, while credit card debt may be seen as “bad debt” because it is typically used for consumer purchases.
Debt to income ratio is a critical metric that lenders use to assess the risk of lending money to someone and by individuals to understand their financial health. By calculating DTI, individuals can improve their financial health by paying down debt, increasing income, or reducing expenses.
It is relevant to note that a good DTI ratio varies depending on the type of loan or credit being applied for, and lenders may have different DTI requirements based on the type of loan. Additionally, while DTI is a valuable metric, it has limitations and should be used with other financial factors when assessing an individual’s financial health and risk.