Debt to Income Ratio Formula

Debt to Income Ratio Formula (Table of Contents)

• Debt to Income Ratio Formula
• Debt to Income Ratio Calculator
• Debt to Income Ratio Formula in Excel(With Excel Template)

Debt to Income Ratio Formula

 

The debt to income ratio is the measure of estimating the capacity of an individual in repaying the debt by comparing his recurring monthly debt to gross monthly income.

Examples of Debt to Income Ratio Formula

Example #1

Let’s take an example for a person Jim, whose Gross Monthly Income is $10000. Jim has a housing mortgage payment of $3000 per month. Jim has also taken a car loan which has a monthly payment of $1000. He also has other smaller debt payments, which amount to $500 per month.

Therefore,

• Overall Recurring Monthly Debt for Jim = $4500
• Gross Monthly Income = $10000

Using the Debt to Income Ratio Formula, We get –

• Debt to Income Ratio = Overall Recurring Monthly Debt for Jim/Gross Monthly Income
• Debt to Income Ratio = $4500/$10000
• Debt to Income Ratio = 0.45 or 45%

Example #2

Generally, Debt to Income Ratios is used by lenders to determine whether the borrower will be able to repay the loan. It is assumed that the highest debt to income ratio is 43%, beyond which the borrower has a diminishing ability to return the loan.

Suppose John has a gross monthly income of $20000 while Alan has a gross monthly income of $15000. John has a recurring monthly debt of $10000, while Alan has a recurring monthly debt of $5000.

Therefore,

Debt to Income Ratio of John is Calculated as:

• Debt to Income Ratio of John = Recurring Monthly Debt/Gross Monthly Income
• Debt to Income Ratio of John = $10000/$20000
• Debt to Income Ratio of John = 0.5 or 50%

Debt to Income Ratio of Alan is Calculated as:

• Debt to Income Ratio of Alan = Recurring Monthly Debt/Gross Monthly Income
• Debt to Income Ratio of Alan = $5000/$15000
• Debt to Income Ratio of Alan = 0.33 or 33%

Hence lenders will be more inclined to lend money to Alan as his debt to income ratio is lower.

Example #3

There are two types of Debt to Income ratio, which are the Front-end debt to income ratio and Back-end debt to income ratio. The front-end debt to income ratio generally indicates the percentage of income which goes towards housing costs, whether it is rent or payment towards a mortgage, which includes both principal and interest. The back-end debt to income ratio encompasses all other recurring debt payments such as car loans, credit card payments, education loans etc.

Lenders use a debt to income ratio of 28/36 to determine whether the borrower should be lent money or not. 28/36 norm indicates that 28% of the gross income can be expensed for housing costs, while 36% can be used to expense all other forms of recurring debt payments.

For example,

• If the gross monthly income = $10000.
• The amount allowed for housing expenses = 0.28*10000
• The amount allowed for housing expenses = $2800
• The amount allowed for housing expenses and recurring debt = 0.36*10000
• The amount allowed for housing expenses and recurring debt = $3600

Therefore, the amount allowed for housing expenses is $2800, and the Amount allowed for housing expenses and recurring debt is $3600

Explanation of Debt to Income Ratio Formula

The debt to income ratio is used by lenders to determine whether the further loan could be issued to the borrower and whether the borrower has the ability to return the loan payments. It is generally preferred that the borrower should have a low Debt to Income Ratio. A ratio of 28% is generally preferable, while 43% is the highest that Debt to Income ratio could be. A ratio of debt to income higher than 43% signals that the borrower might not be able to return the loan taken.

As can be understood from the formula, there are two ways of lowering one’s debt to income ratio. One can either reduce their recurring monthly debt or increase their gross monthly income. Lowering recurring debt payments can be achieved by prepaying some of the loans.

Significance and Use of Debt to Income Ratio Formula

As stated above, lenders use debt to income ratio to determine whether borrowers should be issued new loans or not. There are two types of Debt to Income ratio, which are the Front-end debt to income ratio and Back-end debt to income ratio. The front-end debt to income ratio generally indicates the percentage of income which goes towards housing costs, whether it is rent or payment towards a mortgage, which includes both principal and interest. The back-end debt to income ratio encompasses all other recurring debt payments such as car loans, credit card payments, education loans etc.

Lenders usually use a figure such as 28/36 to determine the amount of the expense that a borrower can afford for it to be eligible to give loans.

Numerator 28 indicates the Front-end debt to income ratio should be 28% of the overall gross monthly income while denominator 36 indicates that the back-end debt to income ratio should be 36% of the overall gross monthly income.

Debt to Income Ratio Formula Calculator

You can use the following Debt to Income Ratio Formula Calculator

Debt to Income Ratio Formula in Excel (With Excel Template)

Here we will do the example of the Debt to Income Ratio Formula in Excel. It is very easy and simple. You need to provide the two inputs, i.e. Recurring Monthly Debt and Gross Monthly Income

You can easily calculate the Debt to Income Ratio Formula in the template provided.

Conclusion

Debt to income ratio is one of the important criteria along with the credit score that is used by creditors to determine whether further debt can be given to the borrowers. The historical limit of 28/36 has been extended since, currently, all over the world, housing prices are higher, and even if borrowers have DTI ratios as high as 50%, they are given loans, albeit maybe at a higher interest rate than others.

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This has been a guide to the Debt to Income Ratio Formula; here, we discuss its uses along with practical examples. We also provide you with a Debt to Income Ratio calculator along with a downloadable excel template.

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