Money Talks, So Should You

Q&A: What is a debt-to-income ratio?

Mechel Glass
by Mechel Glass, Dimespring Contributor  (@CredAbility)

Debt to income ratio – commonly abbreviated as DTI – is a number representing the percentage of a person’s monthly gross income that goes toward paying their obligations.

The ratio is a metric lenders consider when people apply for credit. It helps evaluate an applicant’s ability to take on an additional monthly obligation.

The word debt in this context is often interpreted broadly to include infrequent expenses, like taxes or insurance, in addition to obvious types of debt like credit cards, a mortgage or student loans.

Knowing your debt ratio is a way to answer the question: “Do I have too much debt.”

READ: Q&A: What risk factors lead to debt trouble?

A general rule of thumb is that if you have no more than 35 percent of your monthly income obligated to pay debts, you are in a comfortable place. You should be able to meet your debt obligations, set money aside for savings and have some left over for discretionary things like going out to eat.

As you get above that comfort level, approaching a 42 percent ratio, a potential creditor will view you as someone who has to routinely make choices about discretionary spending. Maybe you occasionally go out to the movies, but can’t swing a dinner out that night. This is a sign your DTI may be getting close to the danger zone.

If your ratio is running between 43 and 49 percent, you are flirting with a financial meltdown. Unexpected things happen in life. And when this person’s car breaks down, or plumbing bursts, their only recourse is probably borrowing more to solve the crisis.

READ: Warning signs of too much debt

When that person borrows to solve the crisis, their DTI goes over 50 percent. At that point they should seek the help of a nonprofit credit counseling agency, such as the National Foundation for Credit Counseling.

These brackets are my rules of thumb, not universal truths. Some federal government housing programs, for example, facilitate loan modifications with a resulting DTI as high as 55 percent.

While a person with a household budget with a DTI that high can succeed through diligence and thrift, it is a much tougher path than the one for the person who kept their ratio below 35 percent.

 

Mechel Glass is vice president of community outreach for CredAbility. She is responsible for coordinating community outreach and financial education activities across the agency’s regions and developing new education programs for both classroom settings and online. Glass, a U.S. Army veteran, is also co-author of “The Veteran’s Money Book,” scheduled for publication in April 2014 by Career Press. The book can now be ordered on Amazon.com.