Debt to Income Ratio - Explained
What is Debt to Income Ratio?
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Table of ContentsWhat is the Debt-to-Income Ratio (DTI)?How is Debt-to-Income Ratio Used?Example of Debt to Income Ratio CalculationAdditional Considerations for Debt-To-income RatioAcademic Research on Debt to Income Ratio
What is the Debt-to-Income Ratio (DTI)?
Debt-to-Income Ratio (DTI) is calculated by dividing one individuals or company's debt payments by his or her or its total income over a specified period, expressed as a percentage.
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How is Debt-to-Income Ratio Used?
The DTI ratio concerns person or company's ability to repay its debt. The creditor, such as a mortgage lender, takes this figure into consideration when lending money. A lower DTI ratio indicates a good financial balance; while a higher ratio suggests one might having difficulty servicing the debt. In the DTI ration, the debt payment is calculated by adding up all the payments you need to make in a given period (generally monthly). The calculation includes the proposed loan amount. The gross income is your total earnings in the period before paying taxes and other deductions.
Example of Debt to Income Ratio Calculation
Olivia pays $400 for her auto loan, $2,000 towards the mortgage and $200 to repay all other loans in a month. Her recurring monthly debt is $400 + $2,000 + $200 = $2800. If her gross monthly income is $8000, then her DTI would be $2800/$8000=0.35 or 35%.
Additional Considerations for Debt-To-income Ratio
It is important to maintain a lower DTI in order to secure a loan from any institution. For example, generally, an institution allows up to 43% DTI while approving a mortgage loan. However, a DTI of less than 36 is preferred. Further, the cost of servicing a mortgage should not constitute more than 28% of the total debt. While the DTI maximum is not the same for all lenders, there is always a better chance of getting a loan or line of credit approved with a lower DTI.
Academic Research on Debt to Income Ratio
- Do loan-to-value and debt-to-income limits work? Evidence from Korea, Igan, D., & Kang, H. (2011). This paper uses regional data and household survey information between 2001 and 2010 to examine the effectiveness of traditional loan-to-value and debt-to-income lending standards. Their analysis finds a weak association between mortgage loans and household leverage, and that such lending limits may affect bubble dynamics by changing the expectations of both parties.
- The growth of US household debt: Demand-side influences, Pollin, R. (1988). Journal of Macroeconomics, 10(2), 231-248. This paper examines the forces at work that have resulted in 40 years of increasing household debt. Underlying, demand-side factors are shown to explain this increase, including demographic changes, the cost of credit, declining incomes, and a general shift in attitude towards debt. Regression analysis confirms the involvement of the more subjective of these factors.
- A Degree of Practical Wisdom: The Ratio of Educational Debt to Income as a Basic Measurement of Law School Graduates' Economic Viability, Chen, J. (2011). Wm. Mitchell L. Rev., 38, 1185. This research uses a variety of formulas to gauge the ability of a student to repay loans for their schooling. Multiple metrics are used to measure the prospective students financial future, and recommendations about borrowing for student loans are made.
- Household debt and income inequality, 19632003, Iacoviello, M. (2008). 19632003. Journal of Money, Credit and Banking, 40(5), 929-965. By constructing a simulated economy, the author of this paper is able to demonstrate that during the time period between 1963 and 2003, the prolonged rise of household debt is due to a concurrent rise in income inequality.
- The balance of payments constraint: from balanced trade to sustainable debt, Barbosa-Filho, N. H. (2004). In Essays on Balance of Payments Constrained Growth (pp. 144-158). Routledge. This article builds upon previous studies that examine the various factors that affect the trade balance of a country engaged in international trade. Exchange rates, capital flows, debt service, and other factors are taken into account when analyzing the long-term growth of a countrys economy.
- Consumer behavior and the stickiness of credit-card interest rates, Calem, P. S., & Mester, L. J. (1995). The American Economic Review, 85(5), 1327-1336. This research examines how and why customers exercise their power of choice in the credit card market. The authors suggest a number of reasons for consumers to behave inconsistently with the rules of perfect competition. Empirical evidence supports their theory with data taken from the Federal Reserves 1989 Survey of Consumer Finances.
- US economic prospects: Secular stagnation, hysteresis, and the zero lower bound, Summers, L. H. (2014). Business Economics, 49(2), 65-73. This address analyzes current economic problems in the U.S. while taking into account modern developments in the field of macroeconomics. Fiscal and monetary policies are discussed in a piece from the President Emeritus of Harvard University.
- Portfolio choice and the debt-to-income relationship, Friedman, B. M. (1985). This research examines the long-term implications of the U.S. debt-to-GNP ratio as it relates to the attitudes of individual investors as they create their own portfolios. The behavior of investors and lenders are examined in relationship to the classic debt-to-income ratio.
- Debt and the consumption response to household income shocks, Baker, S. R. (2014). SSRN Research Paper, 2541142, 1-46. This research examines American households during the Great Depression and their ability to withstand sudden changes in income. Using a new dataset with household income, savings, and credit availability statistics, the author examines the level of change in consumption that upper-class homes may experience during financial shocks. This research also applies the findings to the 2007 2009 recession.
- Inequality, leverage, and crises, Kumhof, M., Rancire, R., & Winant, P. (2015). American Economic Review, 105(3), 1217-45. This paper examines the difference in effect that financial crises can have on high-income versus low-income households. A theoretical model is used to illustrate the pressure that debt can place on households. This model compares similar homes during the three decades prior to the Great Recession.
- House prices, home equity-based borrowing, and the US household leverage crisism Mian, A., & Sufi, A. (2011). American Economic Review, 101(5), 2132-56. This paper illustrates the levels to which home equity loans became a growing part of household debt in the early to mid-2000s. The authors analysis shows that this tactic was more common among young borrowers with low credit scores, and that they often borrowed 25 cents for every dollar that their home increased in value. Overall statistics in household debt and foreclosures are examined.