How do you calculate debt-to-income (DTI) ratio and why is it used by lenders?

• A. DTI = annual debt payments divided by annual income; used to assess borrowing risk.
• B. DTI = monthly debt payments divided by gross monthly income; used to assess borrowing risk.
• C. DTI = monthly debt payments divided by net income; used to set interest rates.
• D. DTI = total assets divided by monthly income; used to evaluate liquidity.

Answer: (B)

DTI measures borrowing risk by comparing how much of your monthly earnings are already committed to debt. To calculate it, add up all your required monthly debt payments—mortgage or rent, credit card minimums, student loans, car loans, etc.—and divide that total by your gross monthly income (your pay before taxes and other deductions). The result is a percentage that shows what portion of your monthly income would be spoken for by debt if you took on more. Lenders use this to judge whether you can realistically handle additional debt; a lower DTI suggests you have more income available to cover new loan payments, while a higher DTI signals greater risk of default.

Using gross monthly income keeps the measure stable and reflective of regular cash flow before deductions, and the monthly basis aligns with ongoing monthly expenses rather than yearly totals. This is why the correct approach is to divide monthly debt payments by gross monthly income to assess borrowing risk.

Why the other approaches don’t fit: using annual figures shifts the focus to a yearly view rather than current monthly capacity; using net income mixes in taxes and deductions which vary and can obscure true ability to pay; and using assets in the numerator or a mis-stated purpose changes what the ratio is about entirely.