Debt-to-income ratio – commonly known as “DTI” in the lending universe – is a major lending criteria any time you apply for a loan. And even if you are not applying for a loan, it is an important measure of how well you are doing in managing your credit, and whether or not you’ve taken on more debt than you can comfortably afford – whether you know it or not.
Most people focus on their credit score when they are trying to improve their financial situation. That’s smart – but don’t overlook the DTI. It’s just as important.
What is Your Debt-to-Income (DTI) Ratio?
DTI is a calculation that totals fixed monthly obligations, then divides them by your gross (before tax) income to arrive at your DTI ratio. It can be a bit confusing, because while it includes your monthly debt payments and certain other obligations, it does not include all of your recurring expenses.
When lenders calculate your DTI, they mainly consider the following monthly obligations:
- Your monthly housing expense, which is either your rent or the principal, interest, taxes and insurance (PITI) on your home.
- The monthly payment on a second mortgage or home equity line of credit.
- Your monthly car payment(s).
- Monthly payments on student loan debt(s).
- Monthly minimum credit card payments.
- Child support or alimony payments.
- Monthly homeowner’s association dues.
- Negative cash flow from investment or vacation real estate, calculated on a monthly basis.
On the other hand, certain other recurring expenses are generally not included in DTI. Those expenses include:
- Monthly utility payments.
- Monthly insurance payments.
- Monthly fees or dues paid to private clubs, gyms, etc.
- School related expenses.
- Monthly insurance payments, including payroll deducted health insurance.
- Monthly amounts paid for variable expenses, such as groceries, gasoline, laundry, or personal services (landscapers, home cleaning services, etc.).
- Costs paid for childcare.
This is what makes DTI difficult to understand by people who are not employed in the lending industry. DTI is calculated only with certain fixed expenses, but not others. It can often be difficult to know what your DTI is before applying for a loan, to say nothing of trying to challenge the lender’s calculation after-the-fact.
A Debt-to-Income Calculation
Understanding a concept like DTI is often best demonstrated by an example. Let’s assume your financial picture look something like this:
- Your total monthly income, $10,000
- Your monthly PITI on your home, $1,800
- Two car payments, $650
- Your minimum monthly credit card payments: $350
- Monthly utility payments, $400
- Monthly insurance payments, $700
- Monthly childcare costs, $800
The total of these expenses is $4,700, so if we divide $4,700 by your total monthly income of $10,000, your DTI is 47%, right?
The last three items on the list – utilities, insurance and childcare – don’t count toward your DTI. They will therefore be ignored in the calculation. Only your house payment, car payments, and credit card payments will count, and they total $2,800 per month. Dividing that by your monthly income of $10,000, and your DTI will be 28%.
Why it Matters to Creditors
Most lenders will evaluate your DTI on most loan programs. As a result, most will have an upper limit as to how high it will allow your DTI to be in order for you to be approved for the credit that you are applying for.
If you are applying for a mortgage, your DTI typically shouldn’t exceed somewhere between 36% and 43% of your income. In the auto lending industry, it’s somewhere around 40%. Credit cards vary by lender, but it’s safe to say that will be difficult to get a new credit line if you’re DTI exceeds 50% of your income.
Your credit score is not the only factor lenders use to determine if they will extend credit to you. They will also look at your DTI, since it is an important factor in determining your ability to pay obligations in the future.
Why Debt-to-Income Should Matter to You
Your DTI is much like your credit score in that lenders will look at it any time you apply for fresh credit. You should want to keep your DTI at a reasonable level (less than 40%) for that reason, but there are two other reasons that may be even more important:
- A DTI significantly in excess of 40% can be the reason why you’re experiencing financial stress – too much of your income is going to service debt.
- A higher DTI can be an indication of impending credit problems.
As your DTI rises above 40%, it is likely that your financial situation will become increasingly uncomfortable. Though you may still be successfully making your minimum monthly debt payments, you’re probably finding it more difficult as time passes.
This is because a high DTI tends to get worse over time. In order to eliminate the income squeeze that a high DTI produces, borrowing against credit lines is often a short-term solution. That only makes your debt problem – and your DTI – worse going forward.
When Your Debt-to-income Ratio Gets Too High
If you’re DTI ratio rises to 50% or more, you will almost certainly enter a personal debt crisis. It means that at least 50% of your monthly income is going to service debt. For most people, that situation is completely unsustainable. When that happens, it’s time to get all hands on deck and take dramatic action.
And there’s another challenge to consider that may even make worse. Remember all of those other expenses we listed earlier that are not included in your DTI calculation? You still have to pay them! Even though your creditors may not recognize them at the time they approved your loans, they are still part of your monthly obligations. And if they are included in your DTI, the ratio will be well in excess of 50%.
It’s easy to see how a high DTI eventually becomes an unsolvable problem. Not only will you not have money to pay for basic living expenses, but you also won’t have extra money for savings. And when that happens, you’ll become completely dependent upon fresh credit, which may not be forthcoming because of your high DTI.
At that point, your credit score will be likely to fall as you max-out existing credit lines to pay your bills. It’s very much a Catch-22 situation, and nearly impossible to escape without professional help. Even then, it could take awhile to fix that score.
A high DTI is an indication of excessive debt. The only way around that is to take decisive action to lower your debts. Of course, the problem is, if you don’t have the extra income, that can’t happen. If you try everything else to lower your debt (including refinancing it), don’t feel stuck.
You can still consider using the services of a law firm that specializes in credit problems. They may be able to help you negotiate with your creditors, or even to consider the possibility of bankruptcy in more extreme cases.
Don’t let too much time pass if your DTI is high. It will only get worse, and the financial stress will eventually take a toll on your health, your ability to earn a living and your ability to enjoy your life.