Oct 26, 2020

Debt to Income Ratio or How to Know Your Borrowing Ability

We are living in a world where debt is both good and bad. Debt finances government and private projects, but it also allows us to buy expensive things from cars to luxury items. 

Being able to calculate how much you can borrow is important when you make big decisions, like buying a house or planning to renovate your kitchen. Debt-to-income ratio (DTI) is the main indicator that helps understand your finances better before such buys. Let's talk about how it's calculated and what's considered a good DTI.

In brief, when you are looking to borrow money, you'll need to know your DTI. 

What's DRI exactly? 

Your debt-to-income ration is a percentage, which is calculated by dividing your total monthly debt by your monthly gross income.

Here is the DTI formulas:

[Monthly Debt] / [Monthly Gross Income] = DTI %

Your DTI shows how well you can manage your debt. Banks and mortgage agencies use DTI when people apply for credit with them. DRI is the metric that helps banks understand how much money they can lend to an individual or family. 

This is why banks and financial agencies want to see several pay stubs and your tax declaration for the previous year. They want to figure out your gross income. They also want to see your expenses: whether you have any outstanding credit card debt or how much you pay for your car (if it's a lease or financing).

Also, lenders always use gross income instead of net income, because it's stable. People may have different deductions, so net income may vary from person to person.

What is good and bad DTI?

Let's look at what's considered good and bad DTI. The lower your DTI, the better it is. In other words,  the lower the percentage (below 20%), the better your perspectives to get the loan are.

Here are the DTI brackets:

GOOD: under 20%
AVERAGE: between 20% and 40%
STRESSED: 40-50%
BAD: Over 50%

Example of DTI Calculation

Here is a young Canadian family without kids. 

He earns 50K per year and she earns 60K. This makes it roughly $9,100 per month (gross monthly income) for their household.

They rent a 2-bedroom condo in one of the provincial centers and would like to buy a house. Their current rent is $1,200 per month.

They also have 1 car with monthly payments of $325 before taxes.

They also pay $100 per month to one of the old credit cards, which they used for expenses when they move into the condo.

Among them the guy is still paying his student debt, which is $100 per month.

Let's see the calculations:

Monthly Gross Income: $9,100

Rent: $1,200
Student loan: $100
Car loan: $325
Credit card payment: $100

DTI:  [1,200 + 100 + 325 + 100] / [9,100] = 18.96%

This couple's DTI is GOOD. The bank will gladly issue a loan to them. 

What's considered debt?

Here is a list of what's considered debt in the DTI calculation.

- mortgage or rent
- home equity loan
- alimony or child support
- car loan
- student loan
- credit card payments

What's the highest acceptable DTI?

43% is considered the highest ratio a borrow can have and still get a mortgage. The rule of thumb is to keep your DTI under 36%. 

Apply these calculations whenever you'd like to understand the health of your personal finances. For a truer picture of your finances, you may want to try the same exercise with net income.