Debt To Income (DTI) Ratio : Calculation Formula, Types and Limitations

Before you start hunting for a new home or apply for a home loan, get in touch with the home loan language. One such term that flashes in a person’s mind is the Debt-to-Income ratio or DTI ratio. It is the most common term when it comes to home loans. DTI is an eligibility criterion for borrowers, and  a way for lenders to assess the credit risk of the borrower.

Let us look at a detailed look at the DTI ratio, its types, importance, limitations ,and understand the calculation process. Get a hang of the ideal DTI ratio, and end with a word of advice to all the home dreamers out there.

Understanding the Debt-to-Income Ratio

Debt-to-Income ratio, as the name suggests, is a comparison between a person’s debt to their income. This is an important factor for home loan eligibility and indicates a person’s spending habits and ability to repay the loan. DTI means how well a borrower can repay their debts at their current gross monthly income. Debt-to-Income ratio is calculated as the percentage of the net monthly debt over the monthly gross income. The ideal debt ratio is considered to be 36% as the front-end ratio and 28% as the back-end ratio. Let’s understand this concept with the help of an example:

For instance, a person with a gross monthly income of INR 60,000 and debt repayment amounting to INR 25,000 has a Debt-to-Income ratio of 41.7%. The borrower has a high Debt-to-income ratio which implies that the borrower faces difficulty in repayment of their debts. The debt of the borrower exceeds their monthly income. A higher DTI ratio makes it difficult for a loan to sanction whereas a lower DTI reflects the creditworthiness and improves their chances.

Importance of Debt-to-Income Ratios

The debt-to-income ratio is a measure of a person’s control over their debt repayment within their income. DTI calculation is important when the talk of home loan is going on as it determines a person’s percentage of income spent on repayment of loans or any other debts. This ratio is directly related to your dream house.

A lower DTI reflects a quality balance between debts and income whereas a higher DTI reflects the borrower’s inadequacy towards payment of their debts. When it comes to house financing, lenders look out for borrowers who meet their criteria the most in terms of DTI. 

A person can improve their debt-to-equity ratio by following these simple steps:

• Monitor your DTI ratio monthly,
• Reduce the EMI payments,
• Try getting a hike,
• Before applying for a loan, postpone any purchase that would add to the debt.

Types of Debt-to-Income Ratios

The debt-to-income ratio can be divided into two types. Lenders use both types to determine the debt repayment efficiency of a borrower.

Front-End Debt-to-Income Ratio

The front-end debt-to-income ratio or the housing ratio compares a person’s gross income to the amount spent on housing costs. The front-end debt-to-income ratio is calculated as a percentage by dividing the housing expense by the gross income. The ideal front-end DTI should not be more than 28%. Housing expense consists of no debts other than the mortgage interest and payments meanwhile, gross income is the income earned before deducting taxes.

Back-End Debt-to-Income Ratio

The Back-end Debt-to-Income ratio accounts for a person’s spending of gross monthly income towards repayment of debts. A back-end ratio has to be less than 36% for a borrower to be termed as creditworthy. The back-end DTI is calculated by dividing the total monthly debt expense by the gross monthly income and multiplying the result by 100.

Total monthly debt expenses include mortgage payments, credit card expenses, loan payments, etc.

For instance, a person has a housing cost of INR 15,000, monthly debt expenses of INR 25,000 and a gross monthly income of INR 60,000.

Front-end debt-to-income ratio = (Housing cost/Gross monthly income) * 100 = 25%

Back-end debt-to-income ratio = (Monthly debt expenses/ Gross Monthly income) * 100 = 42%

Here, it can be concluded that the borrower is effective in paying their housing expenses but is not very efficient when it comes to the debt repayment with their income. The lender will be a little hesitant while lending, keeping in mind the borrower’s capacity to repay the debts.

Calculating Debt-to-Income Ratio

Debt-to-Income ratio or DTI is calculated as the percentage of the monthly debt payments over the gross monthly income. The monthly debt payment consists of repayment of credit card balance, personal loans, student loans, home loans, insurance premiums and taxes. The gross monthly income includes the amount earned before deduction of taxes. The DTI calculation determines if a person is a credit risk or not. A debt burden ratio of 40% is acceptable in India but the obvious choice is the one with a less DTI.

Limitations of Debt-to-Income Ratio

Debt-to-Income ratio, no matter how important it seems, has limitations to it. The interest rate on credit card payment is higher than that on a student loan but the two among other debts are calculated together in the total monthly debt payment. A change would be seen in the debt-to-income ratio, if a person switches form a higher interest credit card to the one that demands lower interest but the debt would remain unchanged. When it comes to home loans, DTI ratio plays a vital role, and a lower DTI would take the borrower a long way.

What is the Debt-To-Income Ratio formula?

The debt-to-income ratio formula is:

Net Monthly Debt Gross Monthly Income 100

This DTI formula can be broken down into two parts:

• Net monthly debt determines the payments made towards all the factors that form a person’s debt on a monthly basis.
• Gross monthly income is the amount earned by a person on a monthly basis. This income is calculated before any taxes are deducted.
• The DTI is calculated as a percentage.

Example to Understand Debt-to-Income Ratio

The Debt-To-Income ratio concept and DTI calculation can be better understood with the help of an example.

Example: A person has an annual gross income of INR 12,00,000. Each month, they are liable to pay an EMI of INR 18,000 as their education loan and INR 7,000 as credit card payment.

Gross Monthly Income = 12,00,000 / 12 = 1,00,000

Total Monthly Debt Payment = 18.000 + 7,000 = 25,000

Debt-To-Income ratio calculation = Total Monthly Debt Payment/Gross Monthly Income*100  = (25,000/1,00,000) * 100 = 25%

Here, the borrower has a DTI ratio of 25% which means they have good control over the debt repayment with their given income. The financial institutions or banks will be happy to provide them with a loan.

Word of Advice for Loan Borrowers

Did you gain a better understanding of the debt-to-income ratio? Before you leave for your dream home loan, here are a few words of advice. If your DTI ratio stands at more than 36%, it would be wise for you to look for ways to lower it. A lower DTI will drastically improve your chances of getting the loan sanctioned. 

Wrapping Up!

A home of your own is the dream of every person and loans make it possible for us to achieve it. Among other things, the debt-to-income ratio is one of the most important factors affecting your pursuit for the dream home. A lower DTI is the key to your home. With this, we will let you drive away in the sunset while calculating your DTI and coming up with ways to maintain the balance.

Frequently Asked Questions (FAQs)