If you’ve ever applied for a loan, the potential lender calculated two important numbers for you as a starting point. The first number is your credit score. Most people understand enough about this piece to know that a good credit score will help you get a loan. The second number that the lender uses is the DTI, or Debt-To-Income Ratio. This page explains what this is and why it’s important for a lender.
Simply put, your DTI is how much money you pay on debt each month divided by your monthly income. The DTI is calculated as a percentage of your income. For example, if you make $3,000/mo before taxes and spend $1200/mo on your mortgage and car loan combined, then your DTI is:
$1,200 / $3,000 = .4 or 40% [note: debt-to-income is always shown as a %]
This means that 40% of your monthly income pays your debt obligations. Now, there are several things that are worth pointing out about this number.
1) The debt obligations only cover your existing loans and/or lines of credit. Your rent would also be included, even if you don’t have a mortgage. “Debt Obligations” does NOT include things like: utilities, gasoline, insurance premiums, tuition, cell phone bill, or other miscellaneous expenses. Things that ARE included would be: housing rent/mortgage, car loan, credit card bill, HELOC payment, unsecured loan, any other loan payment.
2) 40% is typically the maximum threshold for many lenders(although some will go higher depending on circumstances). This means that if you already spend 40% of your income on debt, you aren’t likely to get approved for another loan, even if your credit score is 700+. The reason is because lenders have the data to support the case that if a borrower spends more than 40% of their monthly income on debts, then something is likely to get unpaid each month. They need the rest to pay for things like what I listed above that aren’t debts.
3) Most lenders use “pre-tax” income for the calculation. This isn’t ALWAYS the case, but I’ve normally seen that to be true.
I need to say something here about the calculation for a line of credit. Let’s say you apply for a HELOC and you have a good credit score. Your application is for $100,000 but you only intend to spend $25,000 of it at any given time. How does the lender calculate the loan? The lender will assume you are going to max out the loan from day 1. I’ll give you an example.
A HELOC application for $100,000 with interest-only payments at a 10% rate would be calculated like this:
Step 1) $100,000 x 10% = $10,000(annual interest)
Step 2) Divide $10,000 by 12 months to get your monthly payment: $10,000 / 12 = $833.33
Step 3) The lender will add $833.33 to your DTI to calculate your new percentage.
Even if you truly never use more than $25,000 of the HELOC, the initial calculation is the same. If your balance was $25,000 then your monthly payment would be $208.33, but the loan underwriter would assume the higher amount.
Why is that? Because at any given time you could theoretically max out your loan at $100,000. There’s no stopping you from doing that, so the underwriter must assume worst-case scenario. In the earlier example, the $100,000 application might knock you out of the running because of your DTI. If that’s the case, the lender will likely make you a counteroffer for a lower amount. I’ve seen this happen numerous times.
Why is DTI so important?
The easiest way to remember DTI is that it represents cash flow. How much cash do you have available to pay your debts? The lender must automatically remove cash flow that already pays towards other loans and they can only work with the leftover amount. However, if you are doing a consolidation loan, then the lender can take this into account on the application.
For example, if you currently pay $2000/mo on debt obligations, but apply for a debt consolidation loan with a planned payment of $1300/mo, then you actually free up $700/mo in available cash flow. The lender is likely to do this loan based solely on this information(not counting credit score or prior red flags).
To summarize, DTI is one of the two primary numbers a lender uses to determine whether or not to lend you money. If your credit score is great, but your DTI is too high, you won’t get the loan. If your DTI is low, but your credit score is bad, you won’t get the loan. Both numbers need to be within an acceptable guideline for the lender. Not all lenders are created equal, so the threshold will change. However, the idea is still the same regardless of what financial institution you try to borrow money from.
