Debt/Income Ratio = [debt payments ÷ gross income]
Debt to income ratio tells about the financial position of a person where the load of debt is calculated on his/her monthly income. D/I ratio is commonly used by banks and lending institutions where they measure the capability of a person to return the borrowed amount.
Debt to income ratio is used for internal processing purpose by banks and lending institutions. Sometime people with finance background also refer debt/income ratio as backend ratio. Debt/income ratio is typically used when a person apply for a new mortgage or loan. An important point to not confuse back end ratio or total debt to income ratio with is housing debt ratio also known as front end ratio.
Measuring the capability of a person or company to operate in good financial position after loan approval is an essential part in any type of investment including stocks, bonds, etc. For banks and lending entities, giving loan to an individual or company is an investment. Therefore, financial institutions calculate the debt to income ratio to evaluate the profile of applicant and also to minimize the risk factor by assessing the debt load before approval.
Debt to income vs. debt to limit ratio
Debt to limit ratio is also commonly known as credit utilization ratio and is also sometime confused with debt to income ratio. However, debt to limit ratio is basically a measure of a borrower’s percentage available to use vs. the portion which is utilized by the person.
Debt/income ratio keeps an eye on your monthly debt payments in comparison to your monthly income. While on the other side debt to limit ratio compare your credit limit against the amount you are using from that limit approved by credit card companies.
How managing debt to income ratio can be helpful
Debt to income ratio is primarily used by consumer loans, auto loans, credit cards, mortgage, and other financial entities. Debt to income ratio basically tells about how much of monthly income % is going in to pay the debt payments.
Let’s suppose that if your DTI is 18% then this means that 18% of your monthly gross income is going in to clear the debt payments every month. A higher Debt/income ratio indicates that an individual has too much debt and may not be able to meet his/her liabilities.
Generally, 43% debt-to-income ratio is the highest point where the applicant can still get an approval from a lender but not every lender. The ideal D/I ratio which lender love is 28-36 where 28 means that housing expense must not be more than 28% while on the other side debt-to-income ratio cannot go beyond 36% of gross monthly revenue.
All the expenses which are directly linked with your house are included in housing expense like property taxes, homeowner’s insurance, PMI, flood insurance, home owner’s association fees and more.
How to decrease debt to income ratio
To manage your debt to income ratio one opt for one of two available options. The respective person can either increase his/her monthly income so that if any lender calculates D/I ratio it fall under optimal slab. Another thing which can be done is to reduce the monthly debt payments either by paying-off the loans or by moving debt payments on lower side by increasing the tenure for loan i.e. from 3 years to 5 years.