Debt-to-Income Ratio Definition
The debt-income ratio (DTI) is exactly what it sounds like. It is calculated by adding up all monthly debt payments and dividing by gross monthly income.
Debt-to-Income Ratio Application
Lenders calculate a loan seeker’s DTI to evaluate their ability to repay any additional loans. You will often hear about DTI when applying for a mortgage, and lenders prefer to see no more than a 36% DTI, with only 28% going towards the housing payment. Some lenders will consider approving a loan if the applicant has a DTI up to 43%.
Calculating Debt-to-Income Ratio
Step 1: Add up your debt payments, which include:
Car payment
Student loan payment
Rent/mortgage (including escrowed tax and insurance payments)
Credit card payments (minimum)
Personal loan payments
Child support and alimony
·Note: the following are NOT included in the debt-to-income calculation:
Monthly utilities (water, garbage, electricity, or gas bills)
Car Insurance
Cable bills
Cell phone bills
Health Insurance costs
Groceries/food or entertainment expenses
Step 2: Add up your gross (pre-tax) income, which includes:
Hourly wages
Salary
Tips
Bonuses & commissions
Pension
Social security
Child support and alimony
Side hustle income (if verifiable form tax returns)
Disability income
Income from investments
Step 3: Divide your total debt payments by your total gross income
An Example Case Study
Andrew has a student loan payment of $250 and a car payment of $300. He does not carry a balance on his credit cards, nor does he pay alimony or child support (because he has no ex-wife or kids). He has never taken out a personal loan. Andrew pays a monthly health insurance premium. He also pays for his utilities and cell phone. Remember, health insurance, utilities, and cell phone payments are not included in this calculation. He makes $48,000 per year in salary from his 9-5 job and $5,400 doing his side hustle.
Andrew is considering putting 10% down on a $200,000 house, which would make his payment about $1,300, including principal, interest, insurance, taxes, and private mortgage insurance.
He knows a potential lender will take the following steps to calculate his DTI, so he calculates it himself:
Monthly debt payments, including the proposed mortgage payment:
Student loan payment: $250
Car payment: $300
House payment: $1,300
Total: $1,850
Gross income:
Salary: $48,000
Side hustle: $5,400
Total: $53,400
Monthly: $4,450
Overall debt-to-income Ratio: $1,850/$4,450 = 41.6%
Housing DTI: $1,300/$4,450 = 29.2%
There is a chance Andrew would be approved, since some lenders will accept up to a total 43% DTI. He knows he would be better served to have a DTI below 36% and a housing DTI below 28%. He can accomplish this by lowering his debt payments and/or increasing his gross income:
Andrew could pay off his student loans.
He could pay off his car.
Andrew could look at buying a cheaper house.
He could make a bigger down payment on the house.
Andrew could ask for a raise at work (based on merit and accomplishments, not his desire to buy a house)
He could do more work at his side hustle.
Andrew only has enough cash to either pay off one of his existing loans (student or car) OR buy a house. He would rather keep the existing loans as they are and buy the house, and he wonders what his DTI would be if over the next year he scored a 5% raise in salary, made an additional $3,000 at his side hustle, and put aside enough cash for a 20% down payment on a $180,000 home. The new proposed housing payment would be $1,100.
Andrew’s DTI after one year would be:
Monthly debt payments, including the proposed mortgage payment:
Student loan payment: $250
Car payment: $300
House payment: $1,100
Total: $1,650
Gross income:
Salary: $50,400
Side hustle: $8,400
Total: $58,800
Monthly: $4,900
Overall debt-to-income Ratio: $1,650/$4,900 = 33.7%
Housing DTI: $1,100/$4,900 = 22.4%
If Andrew takes those proposed steps, he will be well within the 36% total debt-to-income and 28% housing debt-to-income guidelines lenders look at when approving loans. He sets to work at his side hustle and sets a performance review meeting with his boss.
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