Definition
A debt income ratio is the percentage of a consumer’s monthly gross income that goes toward paying debts. There are two main kinds of DTI, as discussed below.
Debt to Income Ratio
The Debt to Income ratio is the formula to help lenders in estimating the amount of money they should lend out. This figure takes into account the value and frequency of long term debt that a borrower has accrued.
In simple words, a Debt to Income ratio is the percentage of an individual’s gross monthly income that is spent in repaying debts. However, the Debt to Income Ratio does not just cover debts, but also fees, insurance premium and taxes.
How DTI is used
Lenders carefully consider the DTI of a borrower in order to analyze and assess their financial history, before lending money to them. The lower the value of DTI a borrower has, the better the chances to get a loan.
In order to calculate a borrower’s Debt to income ratio, lenders use a simple method: Firstly, the borrower’s existing debt payments are carefully examined, as well as the projected payments for the new loan they have applied for.
The lender then makes an approximate calculation of the total percentage that portrays the borrower’s income before the deduction of taxes. This percentage signifies the DTI, which serves as an important factor in determining the approval and extension of a loan.
DTI and its types
There are two major types of Debt to Income Ratio which are expressed in the form of a pair.
- Front end Debt to Income ratio
- Back end Debt to Income ratio
The front end Debt to Income ratio represents the percentage of a consumer’s earnings that are spent in housing. This includes all the costs of housing and living; the rent, the mortgage payment, the maintenance, the insurance, association fees and all applicable taxes.
The second type of DTI which is the back end ratio represents the percentage of a consumer’s income that is spent in the repayment of debts plus all those included in the front end ratio. It also includes other debts like credit card billings, student loan payments, car leasing payments, any legal owing, alimony payments, and other form of arrears.
Further Reading
- Portfolio choice and the debt-to-income relationship – www.nber.org [PDF]
- The growth of US household debt: Demand-side influences – www.sciencedirect.com [PDF]
- Household debt and financial assets: evidence from Germany, Great Britain and the USA – rss.onlinelibrary.wiley.com [PDF]
- Financial variables associated with successful debt liquidation – onlinelibrary.wiley.com [PDF]
- Debt and economic activity in the United States – www.nber.org [PDF]
- A Degree of Practical Wisdom: The Ratio of Educational Debt to Income as a Basic Measurement of Law School Graduates' Economic Viability – heinonline.org [PDF]
- Household debt burden and financial vulnerability in Luxembourg – ideas.repec.org [PDF]
- Is there a debt service channel of monetary transmission? – papers.ssrn.com [PDF]
- Household debt and income inequality, 1963–2003 – onlinelibrary.wiley.com [PDF]
