What is Debt-to-Income Ratio and How to Calculate it?

To achieve your goals and manage your money effectively, you should understand the key metrics of personal finance. One of the vital metrics is the debt-to-income ratio or DTI. If you are planning to apply for a loan, buy a house, or assess your financial health, knowing your DTI will provide valuable insights to you.  

It’s a simple and powerful indicator that will significantly impact your ability to secure credit. But most people don’t know about the term completely, so through this blog we can delve into what is debt-to-income ratio, how to calculate and why it is important for financial journey in detail.  

What is Debt-to Income Ratio?

The debt-to-income ratio (DTI) is a personal finance measure that will compare your total monthly or annual debt payments to your monthly or annual income. It shows the answers as a percentage, and you can easily understand how much of your income is dedicated to covering your debts. And also, DTI is an essential component of the risk assessment process because it will provide a clear picture of how much your income is already tied up.  

Lenders like banks and credit unions are using the DTI ratio as a critical tool to assess your creditworthiness and your capacity to take out a new debit. If you have a low DTI, it means you have a good balance between your income and your debt, so you don’t struggle with additional monthly payments. But if you have high DTI, make lenders hesitant to approve new loans because it signals financial strain.  

How to Calculate Your Debt-to-Income Ratio?

The calculation of your debt-to-income ratio is a straightforward process, but it needs the correct information about your monthly debt payment and your gross monthly income. Here’s a step-by-step guide: 

Step 1: Calculate Your Total Gross Monthly Income 

Gross monthly income means the total amount of money that you earn in a month before taxes, reductions, or payroll contributions are taken out. This includes;

🠖 Commissions 

🠖 Bonuses 

🠖 Tips 

🠖 Child Support 

🠖 Social Security Benefits 

🠖 Disability Income 

🠖 Any other regular income sources 

Step 2: Calculate Your Total Monthly Debts 

Next you sum up all your monthly debt payment, that include the following; 

🠖 Housing Payments (like rent payments, monthly mortgage payment, house owners’ association fees, etc.) 

🠖 Loan Payments (like education loan, personal loan, any other installment loan payments, etc.) 

🠖 Credit Card Payments 

🠖 Other Debts 

Important Note: If you are calculating your DTI, certain regular expenses are not included that include;  

🠖 Groceries 

🠖 Utilities 

🠖 Bills (phone, internet, insurances) 

🠖 Transportation 

🠖 Taxes (income and sales tax) 

🠖 Entertainment expenses 

🠖 Savings 

Step 3: Apply the Debt-to-Income Ratio Formula 

Once you calculate your total gross monthly income and your total monthly debts, now you apply this formula; 

Debt-to-Income Ratio (DTI) = (Total Monthly Debt Payments ÷ Gross Monthly Income) × 100 

Example:  

If your monthly debt is ₹33,000 (including your rent, car payment, and credit card minimums) and your gross monthly income is ₹1,00,000. 

Calculate DTI through; 

DTI = (₹33,000 ÷ ₹1,00,000) × 100 DTI = 0.33 × 100 DTI = 33% 

You can also use a debt-to-income ratio calculator online like Wells Fargo’s or Calculator.net. By using these calculators, you can easily get the findings but understand the manual process and ensure you’re including all relevant figures accurately.  

Why is it Important to Know the Debt-to-Income Ratio? 

Knowing your debt-to-income ratio is very important because that impacts both your immediate financial standing and your long-term financial goals. Some of the major factors are detailed below; 

Lender Assessment for Loans 

DTI ratio is a primary metrics lenders use to determine your eligibility for loans, but the limit of DTI varies depending on loan products and lenders.  

a) Below 36%: It is considered a good DTI. Lenders view this as a healthy balance, confirming that you can manage existing debts and are comfortable providing new loans to you.  

b) 36% to 43%: This range is often acceptable particularly for mortgage lenders using a “back-end” ratio that includes housing costs. However, it might require a strong credit score.  

c) Above 43%: It seen as a high DTI, some lenders might approve loans with a DTI above this, but it comes with higher interest rates or stricter terms.   

Financial Health Check 

Your DTI provides a clear picture of your personal financial health. So, if you have a high DTI, it means too much of your income is going towards debt and less savings. Regular checking of your DTI will help to monitor your financial well-being and identify if you’re becoming overleveraged. 

Informing Financial Decisions 

Knowing your DTI will help to make informed decisions about taking on new debt. It can guide you on how much debt-to-income ratio is good for your personal situation.  

Risk Management 

The high DTI leads to many unexpected financial challenges like job loss, medical emergencies, or other expenses. So, you should maintain a lower DTI to reduce this financial risk and build resilience against life’s uncertainties. 

Conclusion

Don’t think that debt-to-income ratio is just a number; it is a critical barometer of your financial stability and your ability to manage debt effectively. A healthy DTI not only opens doors to better lending opportunities, but it also offers responsible financial management. Regularly monitoring and actively working to improve your DTI is the smart step that you are taking for your financial future.  

Discover how Navia can simplify your investments, open your account today! 

Do You Find This Interesting?

Frequently Asked Questions

DISCLAIMER: Investments in the securities market are subject to market risks, read all the related documents carefully before investing. The securities quoted are exemplary and are not recommendatory. Brokerage will not exceed the SEBI prescribed limit.