There are lots of important signals that can help assess the financial health of both individuals and businesses, but one of the most frequently used is the debt-to-income ratio. Read on to find out more about how this metric is used and why, plus how to calculate it yourself.
Definition
What is a debt-to-income ratio?
The debt-to-income ratio (DTI) is pretty much exactly what it sounds like it should be: the ratio of debts to income. This can be for individuals, small businesses, or even enterprises. This metric is one of the most important in assessing financial health for lenders since it speaks to how financially stretched a loan applicant is.
For a general rule of thumb, debt of 30 to 45 percent of income is often considered anything from optimal to acceptable. The actual DTI that's ideal varies widely between applications and the reason that you're looking for this number.
How it's used
Where is debt-to-income ratio used?
Most often, debt-to-income ratios come up in discussing personal finance, especially mortgage loan applications. Although other loans look at this figure, it's often less prominent, and many people don't even realize it's part of the equation. But for mortgage loans, DTI is very upfront, and most people realize it's a number that's as important as their credit score when it comes to whether or not they'll be approved for their loan.
However, debt-to-income ratios are also important for businesses, with smaller businesses needing to pay better attention than larger ones. Small businesses often have to rely on traditional credit sources like banks, so their debt-to-income ratios are just as important as they are for individual borrowers. Enterprises have less to worry about since they often use alternative credit sources, but investors may be interested in the ratio of debt to income of these businesses, too.
How to calculate
How to calculate debt-to-income ratio?
Debt-to-income ratios are pretty simple to calculate. All you need to know is the amount of monthly debt payments and the amount of monthly income. Then, you plug them into this formula:
D = monthly total debt
I = monthly total gross income
DTI = D / I
So, if your monthly debt totaled $1500 and your monthly gross income totaled $4000, your debt to income would work like this:
$1500 / $4000 = 0.375 or 37.5%, which is a pretty decent DTI for most purposes.
Debts that are included are those that have a regular payment involved – things like mortgages, notes, and revolving credit.
Related investing topics
Why it matters to investors
Why does debt-to-income ratio matter to investors?
Investors can use debt-to-income ratios in a variety of applications, depending on what they're investing in. For example, if they're actually involved in direct lending, debt-to-income ratios will matter a lot in determining the risk of a loan applicant and, therefore, the amount of interest that's appropriate to charge.
For other investors, debt-to-income ratios may come into play if you buy things like mortgage REITs or mortgage backed securities (MBS). MBS are often rated by a variety of factors, of which the debt-to-income ratios of the loan holders can be included. Mortgage REITs also invest in mortgage notes, which are once again rated by lending signals like DTI.
Lastly, investors may want to look into the debt-to-income ratios of businesses they're interested in buying into. It's important that a business understands how to leverage debt, so having some debt is good, but too much debt is a disaster waiting to happen come the first downturn. So, this can be an important calculation to do before opening a new stock position. For many types of businesses, 30 to 40 percent is the sweet spot.
