Debt-to-income Ratio: What It Is & How to Calculate It

The definition of debt-to-income (DTI) ratio, is a term and/or a calculation used by institutional and private lenders to identify a borrower’s overall financial situation pertaining to debt and the income that comes in on a monthly basis. Simply put, a borrower’s debt-to-income ratio is the relation between what you owe and what you make.

The two main types of Debt-to-Income (DTI) ratios are:

• Front-end DTI Ratio: This focuses on housing costs. It calculates the percentage of your gross monthly income that goes towards housing expenses, including your mortgage payment, property taxes, homeowner’s insurance, and homeowner’s association (HOA) fees, if applicable.
• Back-end DTI Ratio: This is more comprehensive, taking into account not just your housing expenses, but all monthly debt obligations. This includes credit card payments, car loans, student loans, personal loans, and other debts in addition to your housing costs, divided by your gross monthly income.

To calculate a borrower’s DTI ratio, a lender or underwriter would take the borrower’s monthly debt payments (such as house, credit card, and payments) and divide it by your monthly take-home income.

In other words, a simple way to calculate your debt-to-income ratio is to take your monthly debt payments divided by your gross monthly income. The result is expressed as a percentage and tells lenders how much of your income goes toward debt.

1. Let’s assume a borrower earns $6,000/month which would be considered their over-all gross monthly income. If that same borrower have a car payment of $600/month and a house payment of $1,500/month, total credit card payments of $175/month and a motorcycle payment of $375/month, when you add these monthly amounts together, the end result is your monthly debt/fixed expenses.

To establish a borrower’s debt-to-income ratio, divide their monthly debt payment by their monthly income. The end result is your debt-to-income ratio.

Monthly Income: $6,000
Total Monthly Debt Payment: $2,650
Debt to Income Ration = $2,650 / $6,000 = 44%

Remember, you’re dividing your monthly debt payments by your income before taxes, not your take-home pay.

After the lender calculates the borrower’s debt-to-income ratio, it’s time to discover what the ratio is showing us. If a ratio of 10% to 20% or less, it means the borrower has an excellent debt-to-income ratio. This means that the borrower’s over-all monthly income is significantly higher than what they owe in outstanding debt.

That being said, if the borrower has a debt-to-income ratio of 35% to 39% or higher, it means that the borrower is taking on too much debt in relation to their income, in the eyes of most traditional lending institutions.

After the Sept 2008 banking crash and national capital freeze, anything over 35% to 39% is considered risky since it will be difficult to continue to cover your monthly debt obligations with your current income (pertaining to residential mortgage loans).

Prior to the 2008 banking melt-down the average accepted DTI was 45% to 55% (a huge difference).

Most lenders and banks are even more stringent when deciding a commercial mortgage loan which typically requires a 27% to 32% DTI according to most national chain-banks such as: Wells Fargo, Chase, etc.

Different loans have different DTI limits, reflecting the lender’s perception of risk. Below is a brief overview of the preferred debt-to-income ratios for different loan types. 

• Conventional loans: Typically, lenders prefer a DTI ratio of 36% or lower for conventional loans, though it’s possible to get approved with a DTI as high as 43%. This type of loan often requires a higher credit score and a larger down payment but offers flexibility in terms of mortgage insurance.
• FHA loans: Loans backed by the Federal Housing Administration are a bit more lenient, allowing a DTI ratio up to 43% as a standard, but you can still get approved with a DTI ratio as high as 50% in some cases. FHA loans are popular among first-time homebuyers due to their lower minimum down payment and credit score requirements.
• VA loans: These loans, guaranteed by the Department of Veterans Affairs, are for veterans, active-duty service members, and some surviving spouses. VA loans are quite flexible regarding the DTI ratio, with many lenders looking for a DTI ratio of 41% or lower, although exceptions can be made based on the overall strength of your financial profile.
• USDA loans: Aimed at rural homebuyers and backed by the United States Department of Agriculture, USDA loans sometimes prefer a DTI ratio of 29%/41% (29% for housing costs and 41% for total debt payments). However, higher DTI ratios can be approved with strong credit scores or when the borrower has stable and dependable income.

While these DTI ratios are guidelines, lenders often consider the entire financial picture, including credit scores, savings, assets, and the amount of the down payment. Flexibility in one area can sometimes offset a higher DTI ratio, so it’s always worth discussing your specific situation with a lender.

Most institutional lenders as well as some private lending sources calculate and analyze a borrower’s debt-to-income ratio to determine the size mortgage that the borrower can afford. In fact, a borrower’s DTI, credit score and the borrower’s loan-to-value (LTV) are frequently the most important numbers that any lender looks at when quoting a mortgage amount and interest rate (for loan origination or loan refinance).

This is why it is highly suggested to always pull the borrower’s credit report when creating a mortgage note or creating a business note for resale to a note investor. In addition, this also pertains to note sellers that have included a balloon payment (which we do not suggest in this economy) when structuring a note for resale to a buyer.

Keep in mind that if you as the note seller are relying on a balloon payment to be made after creating a note, the bulk of the return on investment hinges on the borrower being able to be refinanced by a regular bank or lending institution. In this sad economy, this is unlikely to happen if the borrower’s DTI is higher than 30% to 40% depending on the loan amount credit score and loan terms.

The debt-to-income ratio focuses solely on your monthly debt obligations—not your full range of living expenses. While it accounts for loan payments, credit card debt, auto loans, and your mortgage payment (if applicable), it excludes non-debt expenses like:

• Utilities and groceries
• Health insurance premiums
• Subscriptions and memberships
• Taxes and other deductions
• Transportation or childcare costs

These aren’t counted in your DTI calculation because they’re not contractual debts. That said, they still affect your overall financial health, so lenders may review them when evaluating how much of your income goes toward fixed obligations.

Your DTI ratio doesn’t directly impact your credit score, because major credit bureaus don’t use income data when calculating scores. However, DTI and credit health are connected.

Here’s how:

• A high DTI ratio may signal overextension, which could lead to missed payments—hurting your score.
• If you frequently max out your cards, your credit utilization ratio rises, dragging your score down.
• Lenders use your DTI ratio alongside your credit limit, credit report, and credit history to judge risk before you apply for a loan.

In short, while DTI isn’t part of your credit score formula, it affects how lenders view you as a borrower and whether you qualify for the lowest rate personal loan or other financing.

The debt-to-income (DTI) ratio and debt-to-limit ratio—also called credit utilization ratio—are two separate metrics, but both measure how you manage debt relative to your income or credit capacity.

• Debt-to-Income Ratio (DTI):
  A borrower’s debt ratio is derived by comparing their monthly debt payments to their gross monthly income. It’s used to evaluate mortgage applications, personal loans, and other types of installment debt.
• Debt-to-Limit Ratio (Credit Utilization):
  Measures how much revolving credit you’re using compared to your total credit limit. It only applies to credit card debt and heavily impacts your credit score.

Understanding both ratios gives you a clearer picture of your overall debt position—and where to focus if you’re planning to reduce your DTI or improve your creditworthiness.

Lowering your Debt-to-Income (DTI) ratio is a smart move if you’re looking to improve your financial health or prepare for a major purchase, like a home. Here’s how you can tackle it:

• Increase your income: Easier said than done, but boosting your income will lower your DTI ratio. This could mean asking for a raise, finding a higher-paying job, or picking up side gigs.
• Pay down debt: Focus on reducing your debt, especially high-interest credit cards or loans. You can tackle the ones with the highest interest rates first or the smallest balances to quickly see progress.
• Avoid taking on new debt: Resist the urge to open new credit accounts or make large purchases on credit. More debt means a higher DTI ratio.
• Refinance existing loans: If you have loans with high interest rates, see if you can refinance to a lower rate. This can reduce your monthly payments and, as a result, your DTI ratio.
• Consolidate debts: A good first step toward managing balances is using a debt consolidation calculator to estimate how much you could save by combining high-interest debts into one loan. Tools like this can help reduce your DTI while simplifying repayment.
• Budget wisely: Review your spending habits and budget. Cutting back on non-essential expenses frees up more money to pay down debt.
• Use windfalls wisely: Any unexpected financial gains, like tax refunds, bonuses, or inheritances, should be directed towards paying down debt rather than spending.

Is a 20% debt-to-income ratio bad?

A 20% debt-to-income (DTI) ratio is actually quite good and is considered lower than the average acceptable DTI ratio by most lending standards. This low DTI indicates that you are using only a fifth of your gross monthly income to pay off debt, leaving you in a strong position to manage your finances effectively. It suggests that you have a healthy balance between debt and income, which can make you an attractive candidate for lenders if you’re looking to apply for credit or a loan.

What is the average debt-to-income ratio?

The average debt-to-income (DTI) ratio can vary widely depending on factors like age, income level, and economic conditions. Generally speaking, for individuals and households, a common benchmark for a “healthy” DTI ratio is around 36% or lower. This means your total monthly debt payments ideally should not exceed 36% of your gross monthly income.

However, this average can fluctuate. For example, younger individuals might have higher DTI ratios due to student loans, whereas older individuals might have lower DTI ratios if they’ve paid down debts over time. The economic environment also plays a role. During times of economic hardship or high inflation, average DTI ratios might increase as people rely more on credit to manage their expenses.

Keep in mind that the “average” DTI ratio is a broad concept and doesn’t necessarily reflect what’s best for your personal financial situation. Striving for a lower DTI ratio can give you more financial flexibility and better prepare you for future financial goals.

Is rent included in the debt-to-income ratio?

No, rent is not typically included in the calculation of the debt-to-income (DTI) ratio. Rent is considered a living expense rather than a debt obligation. However, when applying for a mortgage, lenders will consider your housing expenses, including future mortgage payments, property taxes, and homeowners’ insurance, as part of your front-end DTI ratio to ensure you can afford the new housing payment in addition to your existing debts.

What is a good DTI ratio for a personal loan?

A good DTI ratio for a personal loan is usually below 36%, though some lenders approve up to 45%. If your DTI is higher, you may qualify only for loans with steeper interest rates. To improve your chances, aim to reduce your DTI or boost your income before taxes.

How do lenders use your DTI ratio?

Lenders use your DTI ratio to determine your capacity to take on additional debt. It helps them assess how much of your monthly income goes toward existing loan payments and if there’s room to safely lend more. A lower ratio generally increases your chances of being approved at better terms.

Can paying off your smallest debt improve your DTI?

Yes. Paying off your smallest debt reduces your monthly debt payments, which lowers your DTI ratio. Even small adjustments can improve your eligibility for credit and lower your risk profile.