What Is Debt-to-Income Ratio?
A debt-to-income ratio (DTI) is a personal finance measure that compares the amount of debt you have to your overall income. Lenders, including issuers of mortgages, use it as a way to measure your ability to manage the payments you make each month and repay the money you have borrowed.
Understanding Debt-to-Income Ratio
A low debt-to-income ratio demonstrates a good balance between debt and income. In general, the lower the percentage, the better the chance you will be able to get the loan or line of credit you want.
On the contrary, a high debt-to-income ratio signals that you may have too much debt for the income you have, and lenders view this as a signal that you would be unable to take on any additional obligations.
- Lenders look for low debt-to-income (DTI) figures because they often believe these borrowers with a small debt-to-income ratio are more likely to successfully manage monthly payments.
- Credit utilization impacts credit scores, but not debt-to-credit ratios.
- Creating a budget, paying off debts, and making a smart saving plan can all contribute to fixing a poor debt-to-credit ratio over time.
Calculating Debt-to-Income Ratio
To calculate your debt-to-income ratio, add up your total recurring monthly obligations (such as mortgage, student loans, auto loans, child support, and credit card payments) and divide by your gross monthly income (the amount you earn each month before taxes and other deductions are taken out).
For example, assume you pay $1,200 for your mortgage, $400 for your car, and $400 for the rest of your debts each month. Your monthly debt payments would be $2,000 ($1,200 + $400 + $400 = $2,000). If your gross income for the month is $6,000, your debt-to-income ratio would be 33% ($2,000 / $6,000 = 0.33). If your gross income for the month was lower, say $5,000, your debt-to-income ratio would be 40% ($2,000 / $5,000 = 0.4).
What’s Considered To Be a Good Debt-To-Income (DTI) Ratio?
DTI and Getting a Mortgage
When you apply for a mortgage, the lender will consider your finances, including your credit history, monthly gross income and how much money you have for a down payment. To figure out how much you can afford for a house, the lender will look at your debt-to-income ratio.
Expressed as a percentage, a debt-to-income ratio is calculated by dividing total recurring monthly debt by monthly gross income.
Lenders prefer to see a debt-to-income ratio smaller than 36%, with no more than 28% of that debt going towards servicing your mortgage. For example, assume your gross income is $4,000 per month. The maximum amount for monthly mortgage-related payments at 28% would be $1,120 ($4,000 x 0.28 = $1,120).
Your lender will also look at your total debts, which should not exceed 36%, or in this case, $1,440 ($4,000 x 0.36 = $1,440). In most cases, 43% is the highest ratio a borrower can have and still get a qualified mortgage. Above that, the lender will likely deny the loan application because your monthly expenses for housing and various debts are too high as compared to your income.
DTI and Credit Score
Your debt-to-income ratio does not directly affect your credit score. This is because the credit agencies do not know how much money you earn, so they are not able to make the calculation.
The credit agencies do, however, look at your credit utilization ratio or debt-to-credit ratio, which compares all your credit card account balances to the total amount of credit (that is, the sum of all the credit limits on your cards) you have available.
For example, if you have credit card balances totaling $4,000 with a credit limit of $10,000, your debt-to-credit ratio would be 40% ($4,000 / $10,000 = 0.40, or 40%). In general, the more a person owes relative to their credit limit—how close to maxing out the cards—the lower the credit score will be.
Lowering Debt-to-Income (DTI) Ratio
Basically, there are two ways to lower your debt-to-income ratio:
- Reduce your monthly recurring debt
- Increase your gross monthly income
Or, of course, you can use a combination of the two. Let’s return to our example of the debt-to-income ratio at 33%, based on the total recurring monthly debt of $2,000 and a gross monthly income of $6,000. If the total recurring monthly debt were reduced to $1,500, the debt-to-income ratio would correspondingly decrease to 25% ($1,500 / $6,000 = 0.25, or 25%).
Similarly, if debt stays the same as in the first example but we increase the income to $8,000, again the debt-to-income ratio drops ($2,000 / $8,000 = 0.25, or 25%).
Of course, reducing debt is easier said than done. It can be helpful to make a conscious effort to avoid going further into debt by considering needs versus wants when spending. Needs are things you have to have in order to survive: food, shelter, clothing, health care, and transportation. Wants, on the other hand, are things you would like to have, but that you don’t need to survive.
Once your needs have been met each month, you might have discretionary income available to spend on wants. You don’t have to spend it all, and it makes financial sense to stop spending so much money on things you don’t need. It is also helpful to create a budget that includes paying down the debt you already have.
To increase your income, you might be able to:
- Find a second job or work as a freelancer in your spare time.
- Work more hours or overtime at your primary job.
- Ask for a pay increase.
- Complete coursework and/or licensing that will increase your skills and marketability, and obtain a new job with a higher salary.