OppLoans.com quoted me in What is the Debt to Income Ratio? It opens,
One of the great things about credit is that it lets you make purchases you wouldn’t otherwise be able to afford at one time. But this arrangement only works if you are able to make your monthly payments. That’s why lenders look at something called your debt to income ratio. It’s a number that indicates what kind of debt load you’ll be able to afford. And if you’re looking to borrow, it’s a number you’ll want to know.
Unless your rich eccentric uncle suddenly dies and leave you a giant pile of money, making any large purchase, like a car or a home, is going to mean taking out a loan. Legitimate loans spread the repayment process over time (or a longer term), which makes owning these incredibly expensive items possible for regular folks.
But not all loans are affordable. If the loan’s monthly payments take up too much of your budget, then you’re likely to default. And as much as you, the borrower, do not want that to happen, it’s also something that lenders want to avoid at all costs.
It doesn’t matter how much you want that cute, three-bedroom Victorian or that sweet, two-door muscle car (or even if you’re just looking for a personal loan to consolidate your higher interest credit card debt). If you can’t afford your monthly payments, reputable lenders aren’t going to want to do business with you. (Predatory payday lenders are a different story, they actually want you to be unable to afford your loan. You can read more about that shadiness in our personal loans guide.)
So how do mortgage, car, and personal lenders determine what a person can afford before they lend them? Well, they usually do it by looking at their debt to income ratio.
What is the debt to income ratio?
Basically, it’s the amount of your monthly budget that goes towards paying debts—including rent or mortgage payments.
“Your debt to income ratio is benchmark metric used to measure an individual’s ability to repay debt and manage their monthly payments,” says Brian Woltman, branch manager at Embrace Home Loans (@EmbraceHomeLoan).
“Your ‘DTI’ as it’s commonly referred to is exactly what it sounds like. It’s calculated by dividing your total current recurring monthly debt by your gross monthly income—the amount you make before any taxes are taken out,” says Woltman. “It’s important because it helps a lender to determine the proper amount of money that someone can borrow, and reasonably expect to be paid back, based on the terms agreed upon.”
According to Gerri Detweiler (@gerridetweiler), head of market education for Nav (@navSMB), “Your debt to income ratio provides important information about whether you can afford the payment on your new loan.”
“On some consumer loans, like mortgages or auto loans, your debt to income ratio can make or break your loan application,” says Detweiler. “This ratio typically compares your monthly recurring debt payments, such as credit card minimum payments, student loan payments, mortgage or auto loans to your monthly gross (before tax) income.”
Here’s an example…
Larry has a monthly income of $5,000 and a list of the following monthly debt obligations:
Credit Card: $150
Student Loan: $400
Installment Loan: $250
To calculate Larry’s DTI we need to divide his total monthly debt payments by his monthly income:
$2,000 / $5,000 = .40
Larry’s debt to income ratio is 40 percent.
David Reiss (@REFinBlog), is a professor of real estate finance at Brooklyn Law School. He says that the debt to income ratio is an important metric for lenders because “It is one of the three “C’s” of loan underwriting:
Character: Does a person have a history of repaying debts?
Capacity: Does a person have the income to repay debts?
Capital: Does the person have assets that can be used to retire debt if income should prove insufficient?
What is a good debt to income ratio?
“If you listen to Ben Franklin, who subscribed to the saying ‘neither a borrower nor lender be,’ the ideal ratio is 0,” says Reiss. But he adds that only lending to people with no debt whatsoever would put home ownership out of reach for, well, almost everyone. Besides, a person can have some debt on-hand and still be a responsible borrower.
“More realistically, in today’s world,” says Reiss, “we might take guidance from the Consumer Financial Protection Bureau (CFPB) which advises against having a DTI ratio of greater than 43 percent. If it creeps higher than that, you might have trouble paying for other important things like rent, food and clothing.”
“Requirements vary but usually if you can stay below a 33 percent debt-to-income ratio, you’re fine,” says Detweiler. “Some lenders will lend up to a 50 percent debt ratio, but the interest rate may be higher since that represents a higher risk.”
For Larry, the guy in our previous example, a 33 percent DTI would mean keeping his monthly debt obligations to $1650.
Let’s go back to that 43 percent number that Reiss mentioned because it isn’t just an arbitrary number. 43 percent DTI is the highest ratio that borrower can have and still receive a “Qualified Mortgage.”