How to Money, Episode Four: Debt to Income Ratio
That’s why on this week’s episode we’re going tackle something that’s a little more obscure: the debt to income ratio, also know as DTI.
What is the debt to income ratio?
Your debt to income ratio is a pretty simple measurement. It shows you how much of your income goes towards paying off debt.
The ratio is measured on a monthly basis. So if you had a monthly income of $3,000, and $1,000 of that money went towards debt payments, then you would have a DTI ratio of 33.3%.
Included in the ratio are any payments made towards personal loans, credit cards, student loans, auto loans, and home loans. If you do not have a mortgage, it also includes the money you put towards rent.
The basic equation for calculating your DTI is:
Monthly Debt Payments / Monthly Income = DTI.
When you’re shopping for a mortgage, it’s important to remember that your potential mortgage payment will replace your rent payment the calculation. When adding up your monthly debt obligations, make sure to account for that.
What is the debt to income ratio used for?
Your DTI is used by potential lenders to help determine whether or not you can afford a given loan.
Basically, the ratio a good idea of whether or not your debt burden is sustainable. If your DTI is already too high, it tells a lender two things:
- You have taken out too much debt
- If you added this loan on top of the loans you’re already paying off, you might have trouble making your payments.
When applying for a home mortgage, a DTI of 43 percent or below will make you eligible for a Qualified Mortgage.
What’s a Qualified Mortgage?
A Qualified Mortgage is a home loan that meets certain specific benchmarks designed to make the loans safe and affordable.
According to the Consumer Financial Protection Bureau (CFPB), a lender that offers a Qualified Mortgage has to make a “good-faith” effort to determine a borrower’s ability to repay their loan.
(Lenders that do not do this are usually predatory and should be avoided.)
In addition to the 43 percent DTI cap, other requirements for a Qualified Mortgage include a loan term no longer than 30 years and no features like negative amortization or an interest-only period of loan payments. Qualified mortgages also can’t include balloon payments at the end of the loan’s repayment term.
What is a good debt to income ratio?
The ideal DTI would be zero. This would mean that the person in question does not have any debt whatsoever.
However, that’s not really feasible for most people.
As a general rule, it’s best to keep your DTI below 33 percent. That means paying less than a third of your monthly income towards debt payments.
A ratio in that range will show most lenders that you are handling credit responsibly. It will mean more approved applications and lower interest rates. Read more about debt to income ratio in our post What is the Debt to Income Ratio?