When applying for a loan, the lender will extensively check the past and current state of your finances to determine your Debt to Income Ratio. They will evaluate your debts and income to compute their ratio, which is one vital factor to determine whether or not you qualify for a loan.
Your debt to income ratio (DTI) is your overall debt payments per month divided by your monthly income per month. It helps lenders like Credit Ninja and other platforms determine if you can afford to repay the loan or if you're in a sound financial position to take on a loan.
How to Calculate the DTI ratio
Calculating your debt to income ratio is pretty simple. However, there's an extra layer of complexity to it because it has two types, namely;
- back-end Debt to Income Ratio
- front-end Debt to Income Ratio
Front-end DTI ratio is the amount of your gross income that goes to a mortgage payment. It also examines how much of your gross income will be allocated to housing expenditures such as homeowners insurance and property taxes.
The ideal front-end DTI ratio should not exceed 28%. If your DTI ratio is higher, it could be an indication that you have issues with making ends meet.
To find out if a borrower can afford a mortgage loan, a lender will compute your back-end DTI ratio. This includes your entire debts along with your current debts with a mortgage payment added in comparison to your gross income.
If the result is quite high, it could be a sign that you don't have sufficient income to pay your daily expenses and debts.
The back-end ratio is usually the default term when we talk about debt to income ratio. It's computed by dividing your debt payments per month over your gross income per month. Your gross income is the money you earned prior to tax deductions, which include any investments, paychecks, or other deductions such as retirement plan contributions and health insurance.
Further, the monthly debt payments within your back-end DTI computation will include your credit card debt, proposed monthly mortgage payment, car loans, student loans, and child support or alimony.
You don't need to include non-debt expenditures like food, utilities, or insurance. To get the percentage used as your DTI ratio, divide the total amount to your gross income per month, and multiply the result by 100.
Front-end DTI = (Housing Expenses/Gross Monthly Income) * 100
Sample Computation for Back-end DTI Ratio
|Total Debt payments per Month||Gross Monthly Income||DTI Ratio|
|$1,500||$2,500||60% (needs work)|
What's the Ideal Debt to Income Ratio?
The straightforward answer is, the lower the back-end DTI ratio, the more ideal the borrower is to the lenders.
43% or less is the ideal back-end DTI ratio because if you have a high DTI ratio, the lenders will generally consider you as someone who's likely to have trouble making repayments.
When You’re DTI Ratio Is:
- Less than 36%. You have manageable debt, and you're likely to have enough money left per month.
- 36% to 49%. Your debt is ok, but it might help to reduce your DTI ratio if you want to get a loan.
- 50% and beyond. More than half your income per month goes to debt repayment. You might have restricted funds left to cover expenses each month.
It's good to have a debt to income ratio of 35% or less as it shows you have manageable debt and that you'll have money left over once you settle all of your bills.
A 36% to 49% range in debt to income ratio is not optimal and should be lower so you can cover any unexpected expenses. For instance, if you plan to apply for a loan with a DTI in this range, your lender may demand additional eligibility requirements.
Also, if you have a 50% or higher debt to income ratio is 50%, your loan options may be narrow since at least half of your income is already allocated to debt repayment. As such, increasing your debt makes it hard for you to prepare for unexpected costs and meet your obligations.
How to Reduce Your DTI Ratio
Although there are various loan options available for people with different DTI ratio, you may still want to minimize your ratio, so you'll know where you stand when applying for different loans.
There are two surefire ways to reduce your DTI ratio: increasing your income and reducing your debt. Take your cue from the tips below.
- Lessen your daily expenses to create a bigger dent in your debts such as your car loan or student loan balances.
- Make additional payments to your credit card to reduce the balance.
- Avoid making unnecessary and large purchases on credit.
- Avoid taking out any lines of credit or new loans.
- Take on freelance work or part-time jobs on the side.
- To boost your income at work, ask for a raise.
You may not qualify for a loan with many lenders if your DTI ratio is too high. But if you find a way to increase your income, or if you're willing to lower your debt load, you can reduce your DTI ratio and be in a good position to get approved for a loan.