How Debt-to-Income Ratio Works

The debt-to-income ratio provides a means to measure an individual's financial situation and status. It reveals how much debt an individual has relative to his income, and the ratio can be used for financial purposes. The debt-to-income ratio assists financial advisers in gaining a better understanding of a client's monetary profile, which may help their clients arrive at more effective financial decisions. The debt-to-income ratio also is used by lenders when determining whether to loan money.

Calculation

To calculate the debt-to-income ratio, a person's total debt is divided by her total income. It may also be calculated by dividing specific types of debt, such as transportation expenses, by total income. Additionally, it can be calculated using annual, rather than monthly figures. The Federal Reserve Board estimates the average American household debt service ratio ranges between 10 and 14 percent. This ratio measures the debt load of a household to indicate whether monthly debt payments are likely to be paid.

Loans

Lending institutions such as banks use the debt-to-income ratio to determine how much financial burden a loan applicant has. In mortgage lending, the debt-to-income ratio is an important indicator of loan risk. A small ratio means less debt and a reduced threat of loan default. The debt-to-income ratio also serves as a lending condition. For example, the Federal Housing Administration requires mortgage debt plus non-household expenses to be no more than 41 percent of total income.

Budgeting

When managing individual finances, a low debt-to-income ratio is beneficial to financial planning. With more available income, higher asset allocations can be made to items such as existing debt and to emergency accounts. For example, the Certified Financial Planner Board of Standards quotes the Dallas News as recommending lower credit card payments when debt-to-income ratio is high. This ensures cash, rather than credit, is used for emergency funding.

Misconceptions

The Fair Isaac Corporation, which created the FICO score, reports that it does not include debt-to-income ratio in its formula to determine a credit score. A ratio that is used in both credit reports and credit scores is the credit utilization ratio. This ratio, also known as the debt-to-credit ratio, measures the amount of a borrower's debt relative to his credit limit. Sometimes the debt utilization ratio is confused with the debt-to-income ratio, but both are used in loan processing.