The Debt to Income ratio or DTI is one of the most commonly used metrics in the lending industry. The lending industry works on taking risks for profits. When a lender gives out a loan to someone, they are taking a chance on the borrower’s reliability. The lender does not know for sure that the borrower will keep good on their promise to make the repayment and to reduce this risk of the borrower defaulting, lenders have been trying to figure out some way to know in advance, at least to a certain degree, about how much risk they are taking.

That is where DTI comes in. This ratio allows lenders to make a reliable judgment about whether they can take a chance on approving the loan to a certain borrower.

Understanding Debt-to-Income Ratio

The value of DTI lies in its ability to be relatively accurate. Research in the DTI has shown this metric to be a reliable predictor that is not just useful for lenders but also for people looking for mortgage loans. To understand this we have to look at what the implications of the DTI ratio are.

The DTI ratio is calculated by considering a person’s debts against their income, taxes not included. The resulting ratio provides an idea about whether it is advisable for a person to take on any additional debt at the time. The higher the ratio, the more there is the risk that the borrower will become unable to continue making payments on the loan. Because a high ratio implies that the borrower has more debt payments to make than they have income.

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The DTI ratio does not take into account things like utility bills or grocery shopping, it only considers credit debt. So if someone has high amounts of debt, especially relative to their income, then it is an indicator of problems. Especially if the borrower has a history of delaying payments or missing the payments. And so, the DTI ratio allows one to have insight into the debt handling ability when considering the ratio.

Calculating Debt-to-Income Ratio

Calculating the DTI ratio is a very simple matter. To calculate DTI you just have to divide the borrower’s monthly debts against the monthly income exclusive of taxes. So step one will be combining all the monthly debts like credit card payments, child support or auto loan payments, etc., and then divide the result by the monthly gross income. To better elaborate on this, let’s try an example.

First the monthly debt, we will assume that a borrower has the following monthly debts:

  1. $500 for an Auto loan
  2. $1000 for student debt
  3. $500 for credit card payments

The monthly debt, in this case, will be 500+1000+500 = $2000

We will assume the borrower has a gross income of $5000 per month. Then the DTI ratio will be calculated as: 2000/5000 = 0.4 x 100 = 40%

In this example, the resulting DTI ratio of the borrower is 40% or 0.4

DTI and Getting a Mortgage

In the market, the highest DTI ratio that is accepted is usually 43%. Although in some cases lenders will accept DTI scores as high as 45% or 50%, these accepted high DTI scores will more likely be cases involving government-sponsored loan programs like FHA loans. Considering in our example the borrower has a DTI of 40% and that this is lower than the 43% accepted in the market, we can be confident that a lender will find this borrower to be an attractive candidate for a mortgage loan.

DTI and Credit Score

Aside from the fact that the lender will consider both a borrower’s credit score and DTI, there is no relationship between the two. DTI scores require knowledge about the income of the borrower and credit scores are calculated by credit agencies. These credit agencies do have access to a borrower’s history of handling credit payments and utilization but no access to information about a borrower’s job or income. The calculation of a credit score considers the following:

– Payment history
– Credit utilization
– Payment delays
– Most recent payments
– Penalties for late payment
– Amount of money owed
– Number of credit accounts

Lowering Debt-to-Income (DTI) Ratio

Considering there are only factors involved in calculating the DTI ratio, it stands to reason that the only way to lower your DTI is to influence those two values. There are two main ways of lowering your DTI:

Reducing monthly debts

This is the simplest thing a person can influence when trying to lower their DTI ratio. But the feasibility depends on what exactly the monthly debts are. For most people, a high DTI ratio is related to the handling of credit card bill payments. While it happens that there are people who don’t handle their finances wisely, in many cases, there are circumstances out of a person’s control that affect their credit. For example, a person might be in a difficult position of paying for an emergency medical procedure and the credit card payment, needless to say, most people will choose to pay for their health first.

If someone’s credit is doing badly this is not a dead-end. It is possible to improve it by making changes. If the reason for bad credit is late payments, they can improve their credit by making payments on time and paying for any pending fees or charges. Improving credit by extension reduces the interest rate charges added to the bills and will lower the DTI as a result.

Increasing monthly income

This one is harder to control because a person’s salary is not exactly under their control. However, there are still steps a person can take to increase their monthly income. One way is to ask for a raise at work, especially if it has been due for some time. It is also possible to increase income by improving performances, getting bonuses from completing additional tasks, or by working longer hours. Another thing to consider is getting a second job if it’s possible. One more thing a person can do is think about adding additional revenue streams to their income, this can be accomplished by investing in stocks for example, or picking up some part-time work on the side.

By increasing the income, the DTI can be brought down to acceptable levels.

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