Debt to income ratios

What Is Debt to Income Ratios?

A debt to income ratio (DTI) is a crucial metric in personal finance that compares an individual's total monthly debt payments to their gross monthly income. Expressed as a percentage, it provides a snapshot of how much of a person's income is dedicated to covering their existing debt obligations. Lenders widely use the debt to income ratio to assess a borrower's capacity to manage additional debt and their overall financial health. A lower DTI generally indicates a greater ability to take on new monthly payments, such as those associated with a mortgage or a new loan.

History and Origin

The concept of evaluating a borrower's capacity to repay debt has long been central to lending practices. However, the formalization and widespread application of the debt to income ratio as a standardized metric, particularly in mortgage lending, gained significant prominence after the 2008 financial crisis. The crisis highlighted the risks associated with inadequate underwriting standards and the origination of unaffordable mortgages.

In response, the Dodd-Frank Wall Street Reform and Consumer Protection Act, enacted in 2010, mandated that mortgage originators determine a consumer's ability to repay a loan. This led to the creation of the "Qualified Mortgage" (QM) rule by the Consumer Financial Protection Bureau (CFPB) in 2014. The rule initially stipulated that for a loan to be considered a Qualified Mortgage, and thus offer lenders certain legal protections, the borrower's debt to income ratio could not exceed 43 percent. This threshold served as a key benchmark for assessing a borrower's repayment ability.¹⁶ While the CFPB later transitioned from a strict 43% DTI limit to a price-based approach for General Qualified Mortgages in 2020, recognizing that a loan's price can also indicate ability to repay, the debt to income ratio remains a fundamental component of lending assessments.¹⁵ Research from institutions like the Federal Reserve Bank of San Francisco has consistently demonstrated a clear, positive relationship between higher DTI ratios and increased mortgage default rates, especially during periods of economic stress.¹⁴

Key Takeaways

• A debt to income ratio compares total monthly debt payments to gross monthly income, expressed as a percentage.
• Lenders use DTI to assess a borrower's ability to manage new debt and their overall financial health.
• A lower DTI generally indicates a healthier financial position and a higher likelihood of loan approval.
• The ratio includes various recurring debts like credit card minimum payments, loan installments, and housing costs.
• Improving your debt to income ratio often involves either reducing monthly debt payments or increasing gross monthly income.

Formula and Calculation

The debt to income ratio is calculated by dividing your total monthly debt payments by your gross monthly income. The result is then multiplied by 100 to express it as a percentage.

The formula is:

Where:

• Total Monthly Debt Payments include recurring payments for debts such as a mortgage or rent, credit cards (minimum payments), auto loans, student loans, personal loans, alimony, and child support. Utility bills are generally not included.¹³
• Gross Monthly Income is your total income before taxes and other deductions are taken out.¹²

Interpreting the Debt to Income Ratio

Lenders typically prefer lower debt to income ratios, as they suggest that a borrower has sufficient disposable income to handle new debt obligations. While specific thresholds can vary by lender and loan product, general guidelines exist. Many lenders prefer a DTI ratio of no more than 36%, with 43% often cited as the highest ratio for a "Qualified Mortgage" in the past.¹¹ However, some lenders, particularly for specific loan programs, may approve loans with DTI ratios up to 45% or even 50% if the borrower has other mitigating factors, such as a strong credit score or significant cash reserves.⁹, ¹⁰

A high debt to income ratio can signal to lenders that a borrower may struggle to make payments, increasing the perceived risk of default. Conversely, a low DTI indicates that a smaller portion of your income is committed to debt, suggesting greater flexibility and financial stability.

Hypothetical Example

Consider an individual, Sarah, who earns a gross income of $5,000 per month. Her monthly debt obligations are as follows:

• Mortgage payment: $1,200
• Auto loan payment: $300
• Credit card minimum payments: $200
• Student loan payment: $400

To calculate Sarah's debt to income ratio:

1. Calculate Total Monthly Debt Payments:
   $1,200 (mortgage) + $300 (auto loan) + $200 (credit cards) + $400 (student loan) = $2,100

2. Apply the DTI Formula:

   $$\text{Debt to Income Ratio} = \frac{\$2,100}{\$5,000} \times 100$$ $$\text{Debt to Income Ratio} = 0.42 \times 100$$ $$\text{Debt to Income Ratio} = 42\%$$

Sarah's debt to income ratio is 42%. This means 42 cents of every dollar she earns before taxes goes toward paying off her debts. While this is above the preferred 36% threshold for many lenders, it may still be acceptable for some mortgage products, particularly if other factors like her credit score are strong.

Practical Applications

The debt to income ratio is a fundamental tool across various financial sectors, primarily in assessing creditworthiness for new credit. Its most common applications include:

• Mortgage Lending: This is perhaps where DTI is most critical. Lenders like Fannie Mae use strict DTI guidelines to determine eligibility for conventional loans, often setting maximum thresholds (e.g., 36% for manually underwritten loans, up to 50% for those underwritten with automated systems and meeting other criteria).⁷, ⁸ A favorable DTI is crucial for securing competitive interest rates and loan terms.⁶
• Auto Loans: Car dealerships and banks assess DTI to gauge a borrower's ability to handle monthly car payments on top of existing obligations.
• Personal Loans and Credit Cards: While less stringent than mortgages, DTI still plays a role in how much a bank might be willing to lend you through a personal loan or how high a credit limit you receive on a new credit card.
• Financial Planning and Debt Management: Individuals can use their DTI to monitor their own financial health. A rising DTI might signal a need for more aggressive budgeting or strategies like debt consolidation to reduce the burden.

The Consumer Financial Protection Bureau (CFPB) provides resources for consumers to understand and calculate their DTI, underscoring its importance in personal financial management.⁵

Limitations and Criticisms

While the debt to income ratio is a widely used and valuable metric, it has certain limitations:

• Does not account for cost of living: A DTI of 35% in a high-cost-of-living area might be more financially burdensome than the same DTI in a low-cost area, as it doesn't consider essential living expenses beyond debt payments.
• Ignores asset levels and savings: The DTI calculation focuses solely on income versus debt and does not factor in a borrower's accumulated savings, investments, or other significant assets. A person with substantial assets might have a higher DTI but still possess strong financial stability, a nuance the ratio misses.⁴
• Doesn't reflect job security or future income potential: DTI is a static measure based on current income. It doesn't incorporate the stability of employment or potential for future income growth, which can significantly impact a borrower's long-term ability to repay debt.
• Reliance on minimum payments for revolving debt: For credit cards, only the minimum monthly payment is typically included in the DTI calculation. This can understate the true financial strain if a borrower carries high balances and aims to pay more than the minimum to avoid escalating interest charges.
• Regulatory shifts: As seen with the CFPB's adjustment to Qualified Mortgage rules, reliance on DTI as a sole determinant can be rigid. The shift to a price-based approach for QM loans acknowledges that other factors beyond a strict DTI threshold can indicate a consumer's ability to repay, promoting greater flexibility in lending while still considering risk.³

These limitations mean that while the debt to income ratio is a strong indicator, it should be considered alongside other factors like credit score, credit history, and cash reserves for a comprehensive financial assessment.

Debt to Income Ratios vs. Credit Utilization Ratio

The debt to income ratio (DTI) and the credit utilization ratio are both important financial metrics, but they measure different aspects of a borrower's financial standing. DTI assesses your ability to manage monthly debt payments relative to your gross income. It looks at whether your income is sufficient to cover all your recurring monthly debt obligations. A low DTI indicates that you have a healthy portion of your income remaining after debts are paid, suggesting you can comfortably take on new financial commitments.

Conversely, the credit utilization ratio measures the amount of revolving credit you are currently using compared to the total amount of revolving credit available to you. It primarily applies to credit cards and lines of credit. For example, if you have a total credit limit of $10,000 across all your credit cards and you currently owe $3,000, your credit utilization ratio is 30%. A lower credit utilization ratio (typically below 30%) is generally seen as favorable and positively impacts your credit score, indicating responsible credit management. While DTI looks at your income's capacity to handle all debt, credit utilization specifically assesses how much of your available credit you are using. Both ratios are key components in a lender's overall assessment of your creditworthiness.

FAQs

What is considered a good debt to income ratio?

Generally, a debt to income ratio of 36% or less is considered good by most lenders, particularly for securing favorable terms on a mortgage. Ratios between 37% and 43% may still be acceptable, especially if you have other strong financial factors. Anything above 43% can make it more challenging to qualify for new loans, as it indicates a higher debt burden relative to income.

How do I calculate my debt to income ratio?

To calculate your debt to income ratio, add up all your recurring monthly debt payments, such as rent or mortgage, credit card minimums, auto loans, and student loans. Then, divide that total by your gross monthly income (your income before taxes and deductions). Multiply the result by 100 to get a percentage. For example, if your total monthly debt is $1,500 and your gross monthly income is $4,500, your DTI is ($1,500 / $4,500) * 100 = 33.3%.²

What types of debt are included in the DTI calculation?

The debt to income ratio calculation typically includes recurring monthly debt payments such as mortgage or rent payments, auto loan payments, student loan payments, minimum credit card payments, and other regular installment loan payments. Obligations like alimony or child support are also generally included. However, everyday expenses like utility bills, groceries, or entertainment costs are not counted.

Can I get a loan with a high debt to income ratio?

While a high debt to income ratio (typically above 43%) can make it more difficult to obtain new loans, it is not always impossible. Some lenders may offer specific loan programs or accept higher DTIs if you have other compensating factors, such as a very strong credit score, significant cash reserves, or a large down payment. However, these loans may come with higher interest rates or less favorable terms.

How can I improve my debt to income ratio?

To improve your debt to income ratio, you can either reduce your total monthly debt payments or increase your gross monthly income. Strategies to reduce debt include paying down high-interest debts, consolidating multiple debts into a single, lower-payment loan, or avoiding new debt. Increasing your income could involve seeking a raise, working overtime, or finding additional income streams.¹ Consistent financial planning and adherence to a budget can help manage and improve your DTI over time.