- Debt-to-income ratio is a metric used by many lenders to determine the balance between your monthly income and the amount you owe to creditors.
- A good debt-to-income ratio is 36% or less. If you know your debt-to-income ratio (and keep it low), you can advocate for a better interest rate.
- You can lower your debt-to-income ratio by paying off your balances.
- Read more stories from Personal Finance Insider.
When applying for a loan or mortgage, one of the factors lenders consider is your debt-to-income ratio (DTI).
Your DTI is an important factor in the borrowing process and shows lenders your ability to repay a loan.
What is the debt to income ratio?
Your debt-to-income ratio refers to how much debt you have relative to your income. This is an important consideration because when a lender approves a loan, they want to make sure you have enough income to pay off the loan.
If you have a lot of debt that makes up a large part of your income, this could be a red flag.
How is the debt to income ratio calculated?
According to the Consumer Financial Protection Bureau (CFPB), “Your debt-to-income ratio is all your monthly debt payments divided by your gross monthly income. This number is one way lenders measure your ability to manage the payments you make each month to repay the money you borrowed.”
Your gross income is the amount of money you earn before any taxes or deductions are withheld. Your debt payments refer to the amount of money you spend on your loans each month.
Let’s say you earn $2,500 gross. Each month you spend $200 on a car loan, $250 on student loans, and $300 on credit cards. That means you’re spending $750 every month managing your debt payments.
To find your debt-to-income ratio, divide your debt payments by your gross income:
$750 ÷ $2,500 = 0.3
Take that number and multiply it by 100 to get your debt to income ratio, which in this case would be 30%. In other words, 30% of your income goes toward your debt obligations.
What is a good debt to income ratio?
If you have a large debt load and are looking to apply for a mortgage or other type of loan, you may be concerned about your DTI ratio. Every lender will rate your DTI, so you want to know what yours is and if it won’t get you credit.
But what is a good DTI ratio? A good guideline is 36% or less. Many lenders use this metric to assess a borrower’s DTI. The smaller the number, the better.
A low DTI ratio can increase your chances of getting a loan approval. When it comes to mortgages, 43% is typically the highest DTI you can use to qualify for a loan.
So if you want a hard and fast number, 36% or less is ideal. But the CFPB offers more specific DTI ratios for specific situations.
For example, it recommends homeowners have a DTI of 36% or less (and no more than 43%), while renters should have a DTI of 15-20%.
Keeping your DTI ratio as low as possible increases your chances of getting a mortgage, car loan, or other type of credit.
Lenders want to know that given your current financial situation, you can afford to make payments on your current loans while taking out a new loan.
Your income plays a big part in what you can afford and the amount you pay each month eats into your income. This is why your DTI is such an important metric for lenders when assessing your eligibility.
How to calculate debt to income ratio
1. List all of your monthly debt payments
Payments on car loans, student loans, mortgages, personal loans, child support, and credit cards all count as monthly debt.
Specifically, the calculation uses the minimum credit card payment that is combined across all credit cards, rather than the amount you actually pay each month. Household bills, health insurance and
Costs do not count as debt.
2. Find out your monthly gross income
Your gross monthly income is how much money you bring home before taxes.
3. Divide monthly debt by monthly income
Dividing all monthly debt payments by monthly gross income gives you a decimal. Move the decimal point two places to the right and you have your percentage or DTI ratio.
Suppose Amelia wants to buy a house for the first time. Her monthly gross income is $5,000, and her monthly debt payments include a $300 car loan, at least $100 in credit card payments, and $400 in student loan payments. Amelia’s debt-to-income ratio would be 16% ($800 / $5,000 = 0.16). With such a low debt-to-income ratio, it would probably be cheap
While the DTI ratio isn’t linked to your credit score — and therefore doesn’t affect your credit report — the two have a fairly symbiotic relationship.
The two most important factors that credit rating agencies use to determine a credit score are payment history and current debt balances – they account for 65% of your credit score. Even though credit scoring agencies don’t have access to an individual’s income, they are still able to consider past behavior to assess the likelihood of making payments on time.
Mortgage lenders typically have the strictest debt-to-income ratio requirements. In general, 43% is the highest rate a borrower can have and still receive a qualifying mortgage. Some mortgage lenders, both large and small, can still approve a borrower who has a debt-to-income ratio above 43%, according to the Consumer Financial Protection Bureau, but they would have to use “reasonable and good faith efforts.” determine repayment ability.
How to lower your debt to income ratio
If you’ve done the math and your debt-to-income ratio is more than 36%, consider lowering your DTI before applying for a loan. To lower your debt-to-income ratio, you have two options:
- Pay off more of your debt
- Earn more
The first option requires you to pay more than the minimum for your debt. Don’t take on additional debt and save on your current balance so your debt doesn’t take up as much of your income.
The second option is to increase your income. You can do this by negotiating your salary at your current job or finding a part-time job to earn some extra money.
If you take these steps to lower your balance and increase your income, your DTI will go down. Once your DTI goes down, you’re in a better position to apply for a loan.