What Is Loan to Debt Ratio?

Excessive debt is as harmful as a poor credit score.
Excessive debt is as harmful as a poor credit score. (Image: hand holding credit card house image by Paul Heasman from Fotolia.com)

Taking out a loan on favorable terms for a major purchase is subject to having a good credit score. The credit score however is only one of two major factors a lender evaluates when determining credit-worthiness. Excessive borrower debt is as alarming as a poor credit score. In personal finance, the loan to debt ratio, more commonly known as the "debt-to-income" ratio (DTI), calculates the borrower’s debt level as a percent of monthly income.

Credit-Worthiness In Personal Finance

When assessing the credit-worthiness of a prospective borrower in personal finance, lenders stay within the strict DTI guidelines set forth in the company’s policies and procedures. Therefore, the borrower should be as informed about her DTI number as her credit score. This number is a calculation of debt and expenses as a percent of income the borrower pays out each month. As a borrower’s debt level increases the DTI also increases, thereby increasing the likelihood that the borrower will fall outside of the lender’s DTI guidelines.

Lenders use the DTI to assess the borrower's debt paying ability.
Lenders use the DTI to assess the borrower's debt paying ability. (Image: consumer girl image by Lev Dolgatshjov from Fotolia.com)

Calculating the DTI

The DTI is usually a calculation of two components. The “front ratio” calculates the borrower’s housing expenses. The “back ratio” includes everything else: installment loans, insurance payments and such payments as judgments, alimony and child support. The two components combined are then calculated as a percent of the borrower’s total monthly income. Joint-borrowers, such as a husband-wife team, obviously have the advantage of two incomes to reduce the DTI ratio.

Some lenders may only use the "back ratio" in calculating the DTI. Therefore, this is the ratio that requires diligent management.

The DTI is usually a two part calculation.
The DTI is usually a two part calculation. (Image: calculation image by Alexey Klementiev from Fotolia.com)

Credit-Worthiness In Corporate Finance

The same principle of debt-to-income applies equally in the field of corporate finance as in personal finance as a means of determining debt serviceability. In corporate finance, the debt ratio is called the “debt service coverage ratio” (DSCR). It is a calculation of income before taxes (net operating income) as a percent of debt payments.

The main difference between the calculations for the DTI in personal finance and the DSCR in corporate finance is that the “numerators” and the “denominators” are reversed. In the DSCR calculation, the numerator is the income while the debt is the denominator. Therefore, a high DSCR ratio in corporate finance is favorable to the borrower, whereas a high DTI ratio in personal finance is unfavorable to the borrower.

Helpful Tips

Debt-to-income ratio guidelines will, of course, differ by lenders, even lenders in direct competition with each other. However, Experian, the credit rating agency, provides prospective borrowers with the following guidelines regarding the "back ratio" of the DTI:

Keep the DTI around 15 percent, certainly no more than 35 percent, which is the average national debt load. When debt gets into the 36 to 42 percent range, its time to implement a workout plan to reduce debt to an acceptable level. Debt in the 43 to 49 percent range is a “red flag” warning that serious financial difficulties are looming on the horizon unless steps are taken immediately to lower debt. Debt in excess of 50 percent is a sure sign of the need for professional help to “aggressively” reduce debt load.

Households should keep the debt load under 35% of income.
Households should keep the debt load under 35% of income. (Image: credit 3d sign image by onlinebewerbung.de from Fotolia.com)

Equal Determinants

Borrowers have a tendency to become fixated on the credit score due to the heavy advertising and publicity surrounding the credit score. It is important to remember that the DTI ranks in equal importance with the credit score in the eyes of most lenders. Therefore, management of the DTI should receive the same amount of diligent attention by families who may need to take out a loan at some time in the future.

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