A person’s debt-to-income ratio (DTI) shows the relationship between the cost of servicing their debt and their gross income. The formula for debt-to-income ratio is shown below:
- DTI = Debt-to-Income ratio
- Debt Payments = Debt payments per period
- Gross Income = Total gross income per period
Typically, DTI is calculated with monthly values, since many times a person pays off debt monthly and also receives income monthly; however, if you make irregular debt payments, as in perhaps you pay off a mortgage monthly but pay off student loans semiannually, it may be easier to calculate DTI with annual numbers. Either way, the formula is the same.
Suppose you have monthly mortgage payments of $2,230, auto loan payments of $260 monthly, and minimum credit card payments of $435 monthly. Also, your gross annual income is $84,000. What is your debt-to-income ratio?
Our first step in any DTI calculation is adjusting all of our necessary values so that they cover the same time span. Here, we have monthly debt payments and annual income, so we can either annualize our debt payments by multiplying each by twelve, or we can convert our annual income to monthly income by dividing by twelve. Since we only have one income and multiple debt payments, let’s convert our gross annual income to gross monthly income. By dividing $84,000 by twelve, we see that your gross monthly income is $7,000. Now, all we have to do is sum the debt payments and divide by gross monthly income to calculate DTI. The work is shown below:
After a quick calculation, we see that your debt-to-income ratio is 41.79%. A debt-to-income ratio that includes all debt payments, as we have done here, is called a “back-end ratio.” Typically, creditors want to see these kinds of ratios at or below 35%, but nowadays, lenders may accept DTI’s as high as 50%.