What is Debt to Income Ratio?
The debt to income ratio (DTI) measures the borrower’s potential to clear the liabilities (payable in instalments) from the monthly income. It is calculated as a percentage of monthly debt payments to the gross monthly income. The lower the ratio, the higher is the borrower’s repayment capability.
Understanding Debt to Income Ratio
Debt to Income Ratio is the ratio between monthly debt payments and the gross monthly income, describing the ability of the investor to repay the debt using the income as the prime payback mechanism.
If an individual takes a loan, the lender needs to know whether the individual is capable enough to pay off the monthly due amount.
For example, if an individual wants to buy a television on equal monthly installments, she needs to produce proof of her monthly income to the lender so that the lender can check whether the individual has been earning enough to pay off the monthly debt amount.
This scenario also happens with a firm too. If a small firm goes to a bank and asks for a loan, the bank will first see how much the firm earns yearly, quarterly, and monthly. If the profit of the firm is enough, the bank will accept the loan proposal.
And to calculate whether an individual or a firm is worthy of a loan, we use the DTI formula.
Before an investor decides to loan a certain amount to a firm, the investor needs to know that the firm is earning enough monthly to pay off his lending amount. This can be true for an individual borrower as well.
Let’s have a look at the formula of debt to income ratio –
Let’s take an example to illustrate the debt to income ratio (DTI) formula.
David has applied for a credit card. He finds out that a credit card would be very useful for him for smaller purchases. The credit card company asks David for proof of his monthly income. The credit card company finds that David earns around $10,000 per month. After a few days, the credit card company informs David that he is eligible for the credit card.
From this example, we can interpret that David is eligible for the credit card because the expected monthly debt payment is far less than David’s monthly income.
If we use the formula, we will understand this clearly.
- Let’s say that the expected monthly debt payment would be $2000 (credit card companies have restrictions that an individual can only expend a certain amount).
Using the formula of DTI, we get –
- Debt to Income = Expected monthly debt payment / David’s monthly income = $2000 / $10,000 = 20%.
Since the expected monthly debt payment is just 20% of David’s monthly income, the credit card company decides to go ahead with David’s application for a new credit card.
Uses of Debt to Income Ratio
DTI Ratio formula is used very broadly. For example, if you apply for a personal loan, the lender will check the debt to income first.
If you apply for a credit card, the lender will check whether you have enough monthly earnings to pay off the due amount. Even for the mortgage acceptance, debt to income is used. The most generic form of checking whether an individual is worthy of getting a mortgage loan or not is to see whether the total debt to the monthly income ratio is 36% or less. If the total debt payment is around 50%, the individual may not be worthy of getting a mortgage loan.
Video on Debt to Income Ratio Formula
This has been a guide to Debt to Income Ratio (DTI). Here we discuss the formula to calculate Debt to income ratio along with practical examples and downloadable excel templates. You may also have a look at these articles below to learn more about Financial Analysis –