What is Debt-to-Income ratio (DTI): Formula to calculate It and Improve creditworthiness

Have you ever thought about applying for a loan or a credit card? Do you recall what criteria the lender used to determine your eligibility? While your income may play a role, it is not the only factor. In reality, before a bank makes a lending decision, they will assess your creditworthiness. This includes calculating your DIY debt-to-income ratio.

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Well, in a more formal sense, before any bank finalises lending you any amount, the check for your creditworthiness.

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‍This check for creditworthiness includes your income sources, possible collateral in case the loan is too big, and lastly, your debt statements.

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The point of concern here is your ‘ability to pay back the loan’ taken by you.

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‍Banks have enough NPAs to deal with nowadays and that makes them even more so when it comes to creating the bad credit- that is, lending to the wrong person. 

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Similar is the case for credit card companies. When you own a credit card, there are quite a few payments associated with it that are not bearable by everyone.

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It makes it important for these companies and banks to check if you are a "worthy borrower’.

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They have to ensure that you don’t carry a bag of debts while applying for their product.

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Because if you do so, you will eventually end up skipping payments and making the situation worse for yourself and definitely create problems for them too. 

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One of the easiest ways to check your creditworthiness is the Debt-to-Income Ratio (DTI). Let's see what it actually means.

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1. What is the meaning of the Debt-to-income (DTI) ratio?

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The DTI ratio is a method to check your borrowing risk. It signifies the percentage of your gross monthly income that usually goes into the payment of debts. 

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The previous statement makes one thing clear- if this percentage of your gross monthly income going into debt repayments is high, then your debt liabilities are high. Is it good for your creditworthiness? Certainly not. 

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The higher it is, the higher would be the suspicion of the banks and definitely leser would be the chances of you getting the amount of your desired loan.

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2. Understanding the DTI ratio- its significance for a borrower

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If you have a low DTI ratio, it simply signifies a good balance between your debt and income.

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That is, the income that you earn is not getting dumped into the debt pool, rather is actually being utilised somewhere else. 

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Conversely, a high DTI ratio would imply that your hard earned income is nothing but just a source of debt payments. 

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The DTI ratio not only signifies a percentage to determine whether you should be given a loan or not but it also estimates how much of an efficient money manager you are. 

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A typical belief is that any person with a low DTI ratio is capable enough to manage his/her monthly debts efficiently. 

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Therefore, banks wish to look at a low DTI ratio before lending money. This makes practical sense since it is profitable for banks to ensure that the borrower is not overextended- that is, doesn’t have too many debts.   

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If you are wondering what the maximum percentage share of debt that gets you qualified for a loan, let’s have a look at some general guidelines: A DTI ratio of around 43% is the ceiling level that you can possess and still get qualified for a mortgage. 

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Furthermore, most banks and companies generally prefer a DTI ratio that’s less than 36%. Out of that36% too, no more than around 28% should be going into a mortgage or rent related payments. 

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Remember that these ratios will definitely fluctuate from lender to lender. Therefore, don’t panic at these statistics. However, as already mentioned, the lower your DTI ratio is, the better.

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3. How is the DTI ratio calculated? What is the formula? 

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Debt-to-Income ratio is nothing but a personal financial measure that compares an individual’s monthly debt payments to their monthly gross income.

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‍So, you can divide your monthly debt payments by your monthly gross income and get your DTI ratio. 

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Your monthly gross income is the one which exists before you deduct any taxes or other payments from it.

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4. Are there any limitations to the use of DTI ratio? 

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So far, you can at least conclude that the DTI ratio is an important financial tool. However, it is not everything.

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By that, we mean that it is only one of the many measures of personal finances used by banks to make credit decisions. 

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Your borrowing history and credit history (& score) are other essential factors that will have to be considered before extending credit. 

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Since your DTI ratio is not a measure of distinguishing between the different types of debts that you hold or how you service them. But your credit history does everything more precisely.

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In your DTI ratio, both credit card debt and student loans will be lumped together, despite the fact that the former holds more weight than the latter.

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In order to get this ‘joint debt’ down, you can transfer your credit card balance to a low interest rate credit card and decrease your monthly payments. 

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Eventually, your monthly debt payments will fall and so will your DTI ratio- leaving the actual outstanding debt unchanged. Check how Credit Card works.

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So you don’t have to worry too much about your DTI since it is only a metric used by banks to make a precise credit decision.

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However, improving it is not a heavy task and would just simply make things much simpler for you.

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A good DTI ratio can be helpful if you are struggling to get a loan. Despite the presence of other factors like credit score and history, DTI still has a huge role to play when it comes to making financial credit decisions. 

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Even if you don’t give it a high weightage, some other lenders may. Therefore, in order to ensure that you don’t lose your creditworthiness, the minimum you can do is to work on your DTI. 

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