When you’re filling out a loan application, your debt-to-income ratio is going to come into play. Why? Lenders need to know that you’ll be able to afford the loan payments before they can approve you for business or personal financing. Being so, they require that borrowers have a debt to income (DTI) ratio under a certain percentage. But how does DTI calculation work and is your DTI good enough to get the loan you want? Read on to learn:
- What a debt-to-income ratio is
- How to calculate your DTI ratio
- Front-end ratio vs. back-end ratio
- Debt-to-income ratio vs. credit utilization
- Why lenders care about debt-to-income ratios
- What a good debt-to-income ratio is
- How to lower your debt-to-income ratio
What is a debt-to-income ratio?
A debt-to-income (DTI) ratio shows how much of your gross monthly income goes toward paying off your monthly debt payments.
For example, if you make $10,000 per month in gross income and spend $5,000 per month on expenses like your car payment, mortgage, credit card payments, and student loan payments, your DTI would be 50%.
When it comes to a business, DTI works the same way but will depend on how much of your business‘s gross monthly income is consumed by its qualifying monthly debt payments.
How to calculate your debt-to-income ratio
Lenders and creditors calculate your debt-to-income ratio by dividing the sum of your total monthly debt payments by your total monthly gross income and multiplying it by 100 to get a percentage.
Monthly gross debt payments
________________________ X 100 = DTI Ratio
Monthly gross income
Continuing with the above example, if your monthly gross debt payments (or debt expenses) total $5,000 and your monthly gross income is $10,000, you would divide $5,000 by $10,000 to get 0.50, and then multiply it by 100 to get a 50% DTI.
Expert tip: If you don’t want to do the math, there are plenty of income ratio calculators that can help (like this one from Wells Fargo).
But what exactly counts as debt payments and gross income when calculating your personal or business DTI?
Personal DTI Breakdown
The monthly bills that are commonly factored into a personal DTI include:
- Rent or mortgage loan payments
- Minimum payments on your credit cards
- Loan payments (auto loans, personal loans, student loans, etc.)
- Child support payments
- Alimony payments
- Timeshare payments
- Property taxes or homeowners insurance premiums (if escrowed)
Monthly expenses that aren’t typically factored into your DTI include:
- Food and groceries
- Entertainment expenses
- Cable, internet, and phone bills
- Car insurance payments
- Health insurance costs
- Utility payments such as water, gas, and electricity
As for monthly gross income, the following types of income are often included in DTI calculations:
- Bonuses and tips
- Social security payments
- Child support
- Other additional income
Business DTI Breakdown
When it comes to business DTI, the expenses and earnings taken into account will be a bit different. Here’s a look at what you can expect.
Monthly expenses commonly factored into your business DTI include:
- Payments to business credit cards
- Business loan repayments
- Rent or lease payments
- Mortgage payments
Monthly earnings commonly factored into your business DTI include:
- Gross monthly income (Pre-tax revenue less the cost of selling goods or services)
Keep in mind that lenders and creditors can vary in the types of debt obligations and income that they count so check with your prospective lender to find out what they include.
Front-end ratio vs. back-end ratio
You might also hear the terms front-end DTI or front-end ratio and back-end DTI or back-end ratio, especially if you’re looking into home loans.
- Front-end DTI refers to how much of a borrower’s gross monthly income is going to housing costs alone.
- Back-end DTI refers to how much of their income is consumed by all of their monthly debt payments (including their proposed monthly mortgage payment).
These DTI ratios are used by mortgage lenders and home buying programs to set restrictions on how much borrowers can afford. For example, to qualify for FHA loans, you’re typically required to have a front-end DTI of 31% or less and a back-end DTI of 43% or less.
Debt-to-income ratio vs. credit utilization
You may have also heard the term credit utilization and wondered how it’s different from DTI ratios. While both compare the amount of debt you have to the total funds you have available, credit utilization solely looks at this ratio within your revolving credit accounts like credit cards and lines of credit.
To calculate it, you divide your outstanding balance by your total line of credit and then multiply the quotient by 100 to get a percentage. So if you have an outstanding balance of $300 and a credit limit of $1,000 you divide 300 by $1,000 to get 0.30 and multiply it by 100 to get your credit utilization ratio of 30%. Sound familiar? It works the same as the DTI formula but for a credit line.
Credit utilization plays a large role in personal and business credit scoring models. It accounts for 30% of FICO’s personal credit scores, only second to payment history which accounts for 35%. Further, Equifax lists it as a key factor in its Business Credit Risk Score, and Experian’s business credit reports factor in how many high utilization commercial accounts a company has.
Being so, it‘s wise to keep your revolving credit balances as low as possible on personal and business credit cards (and lines of credit) to keep your credit scores in good shape.
Why do lenders care about debt-to-income ratios?
Lenders and creditors will usually check your credit scores and credit history when you’re applying for a loan, so managing your credit utilization is important, but they’ll also usually analyze your debt-to-income ratio in-house. Why? Because it shows how much money you have left over each month after paying all of your monthly debt payments. Lenders need to know that information to determine if you’ll be able to comfortably afford your new loan payments.
Further, data from decades of lending has shown a correlation between a higher DTI and a higher risk of default, as is found in this report by the Federal Reserve Bank of Dallas. When a borrower presents more risk, lenders and creditors need to charge them higher interest rates or deny their application.
Long story short — DTIs help lenders and creditors understand how much borrowers can afford and how much credit risk they present.
What do lenders consider a “good” debt-to-income ratio?
A good DTI ratio can vary depending on the type of loan you’re looking for and the lender you choose. However, generally, a DTI of 35% or less is considered good. If your DTI is somewhere between 36% and 49%, you may still get approved but will be seen as a higher risk. Lenders often begin drawing the line and denying borrowers when they have a DTI from 45% to 50%.
For example, Connect2Capital requires that your business has a DTI below 50% if you want to get approved for a business loan. Further, if you want to get a Qualified Mortgage, mortgage lenders require you to have a DTI ratio of 43% or less.
To figure out what DTI limits apply to your situation, you‘ll have to check with lenders offering the loan product you want.
How to lower your debt-to-income ratio
There are two main ways to lower your debt-to-income ratio — you can increase your income or decrease your current debt. That could mean paying off a loan balance to remove a large monthly payment or paying off your credit card debt to get rid of the monthly minimum payments. On the other hand, you could focus on building another stream of income, asking for a raise, or focusing on growing your business’s revenue in a particular area.
How to appeal to lenders overall
Before taking any steps, however, it’s important to consider the bigger picture. Having a low debt-to-income ratio is important, but lenders may also want to see a certain amount of assets (e.g. savings for a down payment) and strong credit scores.
For example, if paying off a car loan to lower your DTI is going to drain your savings and hurt your credit score (by reducing your credit mix), it may not be the best choice. On the other hand, if you can reduce your high DTI without damaging your credit score or depleting your assets, it could make sense.
A good place to start is to review all of a lender‘s requirements for the loan you’d like to get. Then, see how you can move things around on your end to best tick all the boxes while also protecting your overall financial health.