What is the Debt To Income Ratio?
Definition: Debt to income measures the ability of an individual to meet their debt obligations. This personal finance metric compares an individual’s gross monthly income to their debt payments per month.
Usually, gross income is the amount one earns before deductions and taxes.
Debt to Income Ratio (DTI) Example
The debt to income ratio is important to creditors and they use it to determine the ability of a borrower to make monthly debt payments until it is fully settled. Mortgage brokers use this ratio to ascertain that you can manage your debt and in a position to make monthly payments before giving one a loan. Basically, they will use the metric to determine if one’s income is adequate to meet new loan payments and any outstanding monthly debt payments. The individual’s debt payment per month, as well as their current income, is taken into account when calculating the debt to income ratio.
Therefore having a higher debt to income ratio is more preferable relative to a lower ratio. This is because it increases the chances of a creditor advancing credit. After all, they are sure you will meet payment commitments. However, the ratio is just part of the whole process involved in determining the creditworthiness or credit risk of an individual. Other factors such as employment status, credit score as well as an individual’s assets are also considered. This is because the debt to income ratio cannot be used on its own to give creditors thorough analysis.
Debt to Income Ratio Formula
To calculate the debt to income ratio formula you have to get total debts payments per month by considering all debts such as credit cards, insurances, mortgages and loans among others. You also need the individual’s monthly gross income which includes all that the individual will earn before factoring taxes as well as other deductions.
Often the ratio is mistaken to the debt limit ratio that compares one’s credit usage relative to the amount of credit they have available.
Debt to Income Ratio Analysis
Debt to income ratio is an important measure to creditors who use it to ascertain one’s capability to serviced debts. However, it is just part of the credit analysis process which entails establishing the creditworthiness of a borrower. Therefore the ratio should be lower which will increase the chances of an individual receiving a loan from lenders. Although there is no agreeable debt to income ratio a ratio of below 36% is favorable. But one can have a debt to income ratio higher than 36% and the lenders could consider them for a loan if the credit analysis process shows that they have good credit.
If a borrower has a low ratio then it means that they can effectively manage debt payments per month. As a result credit providers and banks will consider individuals with low debt to income ratios for credit advances. The use of the ratio makes sense because the lender wants to be sure that the borrower will not default on payments.
The acceptable standard debt to income ratio varies based on geographical location, prime interest as well as from industry to industry. For instance the DTI a lender will prefer for an individual who wants to purchase a property in a rural setting will be different from in an urban setting. Also, the ratio varies among lenders and they use it to assess the risk to ascertain if an individual can afford a loan. Even if the ratio is higher some lenders can sometimes issue loans that are risky but they charge high-interest rates but most of the time lenders have set acceptable standard debt to income ratio.
Summary
Having a low debt to income ratio is very important for an individual seeking to get a loan. Interestingly they can lower the ratio by increasing monthly gross income or lowering debts by paying them off or settling some parts.