If a borrower is denied credit because the level of debt is deemed to be too high for the borrower’s income, as defined by lender policy, either of the following reasons will be given:
- “debt to income ratio too high”, or
- “loan amount to income amount is too high”
Both statements essentially mean the same thing, that is, the applicant’s income is insufficient to qualify for additional debt.
The applicant receives this adverse action notice as required under federal lending regulations and should clearly state the reason for the denial.
Why do lenders use DTI (debt to income)?
As part of the decision process to grant credit, debt to income ratio (DTI) will help a lender assess every applicant according to creditor policy guidelines, to determine the borrower’s ability to repay.
The debt to income calculation presents the percentage of an applicant’s monthly income already committed to monthly debt payments.
This is important because monthly income is a finite resource. Depending on the amount of debt the borrower is obligated to pay, adding more could result in serious delinquency or default.
It should be noted that the debt to income ratio is only a guideline and can vary among lenders.
It is one of many variables that provides an indication of a borrower’s debt level. One in particular which can be used in conjunction is an applicant’s credit utilization ratio.
The overall purpose of calculating DTI is to protect both the borrower and lender from a potentially negative financial situation.
It is not a restriction based on income, as the same ratios are applied for every borrower.
Remember, it’s not about having ‘enough’ income. Rather, it’s about having an income that is sufficient to take on an additional monthly debt on top of any existing debt you may have.
Most loan terms are for many months or years. Much can happen in that amount of time that will impact a borrower’s financial situation.
Lenders cannot read the future, so they must rely on past behavior and current circumstances to make a decision.
How do you calculate debt to income ratio?
Debt to income ratio is the percentage of your total amount of monthly debt payments over your total amount of gross monthly income (before taxes and deductions are made).
DTI (debt to income) ratio = Total monthly debt payments ÷ Total gross monthly income
Monthly debt payments include:
- any loan repayments
- child support / alimony
- rent
- credit card payments
Note that all debts present on your credit report are included. Also, any other debts disclosed to a creditor through interview or inquiry.
For example, a loan officer may notice there is no mortgage payment on the credit report and request a monthly rent payment.
The questions are to get a better overall understanding of financial obligations and every applicant is asked the same questions.
Monthly income can include:
- salary, wages
- tips, bonuses
- self-employed salary
- child support / alimony
- social security
- pension / retirement
- overtime
- commissions
- dividends
- rent
Income has to be verifiable. “Off the books” or “under the table” income cannot be used when calculating DTI for several reasons but primarily because there has to be a way to prove legitimacy if an auditor requests to see it.
When additional income is not verifiable from regular pay stubs or direct deposits, the lender may request documentation in the form of tax returns or bonus award letters and deposits.
In the case of tips or gratuities, some lenders may use a conservative estimate based on hours worked monthly.
If the additional income is actually from another person within the household, that income can only be used if their debts are also included in the calculation.
It is likely that the lender will require this person to be on the loan in order to use their income and in doing so, will require the same income verification as that of the original borrower.
What is not included in debt to income ratio?
The calculation of debt to income ratio does not include things like:
- monthly bills for utilities, such gas, electricity and water
- grocery expenses
- taxes
- health care
- insurance
Borrowers should be warned that although they may qualify for a loan, the lender would not have taken these expenses into consideration at approval time.
This means that if you have large monthly expenses that fall into this excluded category, the debt to income ratio in reality will be skewed in your favour, despite the potential inability to make consistent repayments.
Always remember to factor these expenses into your budget and to be cognisant that being approved for credit does not necessarily mean that you can afford the repayments.
If your debt to income ratio is already quite high, having these additional expenses may push you beyond your capacity to service the loan comfortably.
What is a good debt to income ratio?
Lenders typically consider a debt to income ratio of 30% or below to be excellent.
However, the impact of DTI on loan approval may depend on such things as your credit report/score, the type of loan for which you are applying, assets in your possession including personal savings.
If, for example, your credit report includes debt in collections (e.g. eviction debt), charge-offs, and/or other delinquent credit issues, a low debt to income ratio may not be quite as effective as it should be in your application process.
In other words, a debt to income ratio of 40% coupled with a great credit score, may be in better shape for lender approval than a debt to income ratio of 30% combined with a poor credit rating.
Below are different levels of debt to income ratios accompanied with a rough level of grading:
| Debt to income (DTI) | Grading |
|---|---|
| < 30% | Excellent |
| 31 – 35% | Good |
| 36 – 40% | Not bad |
| 41 – 45% | Not great |
| > 45% | Unacceptable (exceptions may be made) |
It is the lender’s responsibility to determine credit worthiness of the borrower and also their ability to repay the debt.
Lenders want to approve loans, but these approvals must be within acceptable guidelines so there is no undue financial burden on the borrower and no unnecessary risk for the lender.
Exceptions will sometimes be made, but there must be a valid reason. Anytime an exception is made to loan policy, there will need to be substantial documentation.
Is debt to income ratio important?
Yes, debt to income ratio is important because it quickly illustrates the amount of money the borrower has remaining after all debts are paid.
This percentage is a guideline, and depending on the type of loan, lender, and overall credit worthiness of the applicant, it usually ranges between 30-40% to be acceptable.
Legitimate lenders work within operational guidelines to determine credit worthiness of all applicants.
In addition to assessing credit depth, payment history, credit score, employment status and employment history, creditors must determine if a new debt is reasonable and affordable within the applicant’s financial situation.
A DTI of 30-40% may seem low to some borrowers, but it is actually a generous percentage.
Because gross income does not account for taxes and other federal and state deductions, there is still less to live on than this percentage indicates.
Plus, most borrowers have additional monthly obligations that are difficult to define – i.e. food, fuel, school expenses, childcare.
Some lenders will calculate DTI using net income to gain a better comparison.
Others will include an amount for monthly expenses such as insurance and utility bills in the calculation to determine how much is really left to live on, referring to the calculated ratio as a back-end debt to income ratio.
Does debt to income affect credit score?
No, because the assessment of a credit application is primarily based on your consumer credit report and not your income.
A loan that is denied as a result of the applicant having too much debt in comparison to income is an assessment of what already exists on the credit report.
Credit scores are not lowered based on credit applications being denied.
This process will only impact your credit score when multiple inquiries appear in a short period of time as a result of shopping around with various lenders for credit approval. The multiple inquiries will result in a drop in your credit score.
Bear in mind though that a high debt to income ratio may be an indication that perhaps your credit utilization is also quite high, which has a direct impact on your credit score.
If you have a high credit utilization, it means that the combined balances on all of your credit accounts with respect to the combined credit limit is above acceptable levels.
Paying down your debts and lowering your credit utilization to below 30% will have the cascading impact of also lowering your debt to income ratio.
How to lower your debt to income ratio?
Debt repayment is a top priority. It takes time and diligence to pay off debt, and your credit report will most likely take up to two monthly reporting cycles before it catches up.
Paying off unnecessary debt is an excellent long term approach to better financial health.
Another way to lower DTI is to increase monthly income.
There are many schools of thought on how to go about this. Whichever approach is used, the most important aspects are commitment and consistency.
It takes time, but results will come and your DTI ratio will lower eventually if you make a concerted effort.
Remember to use credit sparingly so that in the event that you apply for a loan, your debt to income ratio will be low enough such that it provides a strong indication of your ability to repay.