The debt-to-income ratio is one of the most important metrics analyzed by lenders to evaluate the creditworthiness of an applicant. The calculation of this ratio is simple and requires basic information that lenders can gather directly from the person or through other channels such as credit reporting agencies.
Lenders will typically analyze five essential aspects of the financial situation of each person who applies for credit to determine whether they are suitable candidates for approval. These variables are designed to help financial institutions pick the borrowers who have a higher likelihood of paying for their financial commitments on time, reducing the risk of late payments and potential defaults.
Understanding the importance of the debt-to-income ratio could help you in the process of applying and getting approved for a personal loan, and in this article, you’ll learn all you should know about this popular financial ratio.
Debt-to-Income (DTI) Ratio Calculation
There are two essential components associated with DTI calculation—the debt service component and the income component. The debt service component comprises any of the borrower’s financial obligations, and in this context, the DTI ratio can be divided into two separate ratios: the front-end and back-end ratio.
The front-end ratio typically incorporates housing expenses, including mortgage payments or rent payments, HOA fees, property taxes, and insurance payments. On the other hand, the back-end ratio adds up the rest of the borrower’s debt payments, including car loans, installment loans, outstanding bad credit loans, credit card debt, child support, student loans, and any other financial obligation assumed by the borrower that imposes a periodical payment.
The income component, on the other hand, is understood as the individual’s gross income, which is also known as the pre-tax income. No deductions are taken into account for this variable, and the most common sources of income for a person are salaries, bonuses, commissions, rental income, dividends, capital gains, and pension payments, among others.
Therefore, the formulas to calculate the debt-to-income ratios are:
DTI (front-end) = Housing Expenses / Gross Income
DTI (back-end) = (Housing Expenses + Other Debt Service) / Gross Income
This metric can be calculated by using monthly or annual information, although it is more accurate to use annual information as some of the above expenses occur only once a year, such as property tax payments.
The Importance of the Debt-to-Income Ratio for Lenders
Lenders use the debt-to-income ratio to understand the borrower’s payment capacity. A high DTI ratio indicates that the borrower’s gross income is exhausted by their current financial commitments, and therefore, there is little room for them to assume new obligations.
In contrast, a low DTI indicates that the borrower has room to deal with additional debt service payments, and therefore, a candidate with a low DTI ratio will be seen as more suitable for loan approval
Even so, the DTI is not the only criteria analyzed by lenders to determine the creditworthiness of an individual. They also may evaluate characteristics such as credit scores, credit history, capital, collateral, and conditions. Nevertheless, the DTI plays a key role in the analysis and could be a decisive factor.
Most lenders establish similar minimum criteria when rating a person’s debt-to-income ratio. The front-end ratio, in most cases, should be lower than 28% for the candidate to be eligible, and the back-end ratio shouldn’t be higher than 36%.
Let’s say a candidate has good credit scores and a strong balance sheet. These two factors are in their favor. However, if the DTI is too high, the financial institution may reject the application because the applicant doesn’t have enough payment capacity to assure the lender that they can be timely with fulfilling their obligations.
This doesn’t necessarily mean that candidates who have higher ratios won’t get approved as the other conditions mentioned above may help in deciding the person’s eligibility. If there’s collateral involved, or certain other conditions are met, the loan could be approved either way, regardless of a higher-than-average DTI.
For this reason, the DTI could play a key role in the final decision regarding a credit application.
Does the Debt-to-Income Ratio Affect my Credit Score?
Credit scoring models don’t incorporate the debt-to-income ratio as they primarily analyze an individual’s credit situation through their credit history.
Lenders are the ones who analyze the DTI. However, since they have the final say in the decision of whether to approve an application, the debt-to-income remains as important as credit scores. Consumers should monitor the evolution of their DTI to make sure they remain within the boundaries of what is usually considered suitable.
Alternatives to Lower your Debt-to-Income Ratio
Since the debt-to-income ratio is such an important metric, especially if you are currently looking to get approved for a mortgage, car loan, personal loan, installment loan, or simply a credit card, you could apply some of these tips to lower your DTI.
#1 – Identify your larger debt service items.
There are two approaches to reduce your debt service payments, which will significantly impact your DTI. You can either cut the small payments you make on various debts, or you could chop the largest item.
If you are currently renting, you could consider moving to a cheaper place. While this may sound extreme, cutting your rent payments will probably have a sizable impact on your DTI.
#2 – Increase the length of your credit.
The longer the credit term of your loans, the lower the minimum payment will be. If you successfully renegotiate the terms of your existing credit accounts to extend the credit terms by a few months, this could reduce your monthly debt service, which as a result will increase your DTI.
#3 – Ask for a raise.
While this may sound obvious, studies show that almost 70% of the people who are brave enough to ask for a raise tend to get at least some kind of adjustment. If you successfully increase your gross income through a raise, your DTI will drop.
#4 – Add Other Income Streams
Today’s gig economy has allowed professionals to do extra work either as a new full-time career path or to earn extra money on the side. Your DTI accounts for all your income sources, and for this reason you should consider diversifying your income streams to incorporate additional money that can reduce the resulting ratio.
#5 – Pay off some of your debt.
If you have some savings at hand, and you are trying to improve your DTI, paying off a portion of your debt will lower the ratio, not only saving you money from interest expenses but also increasing your chances of getting approved for a loan.
These are only some of the strategies you could implement to reduce your DTI, and you can probably think of some other creative ways to achieve this goal. The important thing is to keep track of how your DTI evolves while you implement each of them.
By using the formulas above, you can determine how your strategies will impact your current DTI, either by reducing your current debt service payments or by increasing your income.
Is It Possible to Get a Personal Loan if I Have a High DTI?
Traditional lenders may be willing to extend personal loans regardless of a DTI that is higher than their minimum criteria. Nevertheless, these loans will usually come with an extra set of conditions including collateral, co-signers, higher interest rates, smaller credit limits, or shorter credit terms.
Lenders are ultimately looking to compensate for the additional risk they are taking, and those are some of the ways they would do it. On the other hand, other non-traditional lenders, such as CreditNinja, can help you by extending you an unsecured personal loan.