When we look to borrow money, our credit score is the first measuring stick we often think about. While our credit score is a vital figure in determining our ability to repay a loan, lenders will also often review your debt-to-income (DTI) ratio. Along with your credit score, your DTI ratio can determine how much of a credit risk you may be based on how much money you’re earning—and how much you owe.
Keep reading to learn more about what debt-to-income ratio is, how it’s calculated, what’s considered a “good” DTI, how you can lower yours if necessary, and more.
What Is Debt-to-Income Ratio?
Debt-to-income ratio is a formula that shows lenders how much of your income goes toward debt payments each month. Debts included in a DTI ratio include your mortgage or rent, car payments, student loans, credit card payments, real estate taxes and homeowners insurance, personal loan payments, child support payments, and co-signed loan payments.
When it comes to a mortgage loan, lenders often consider two types of DTI. The first is your front-end DTI, which examines how much of your gross income goes toward housing costs (mortgage, property taxes, and homeowners insurance). The second is your back-end DTI, which compares your gross monthly income to your housing costs and other debts—such as car loans, credit cards, and student loans.
How Debt-to-Income Ratio Is Calculated
As previously mentioned, DTI is a formula. It’s actually simple enough to figure out before you begin the loan application process:
- Total up your monthly debt payments, such as your rent or mortgage, student loans, minimum credit card payments, and car payments.
- Add up your gross monthly income—how much you earn before tax deductions.
- Divide your monthly debt payments by your gross monthly income to get your debt-to-income ratio.
If your mortgage is $2,000, you have a $500 a month car payment, and you pay $300 per month for your student loans, your monthly debt is $2,800. If your gross monthly income is $5,600, you’d divide $2,800 by $5,600 to get your DTI ratio, which is 50%:
$2,800/$5,600 = 50%.
More information here:Why Lenders Consider DTI Ratio Important
Similar to your credit score, lenders use DTI to determine how big of a risk it would be to have another payment to handle. DTI measures how likely you are to repay your loan—it’s especially key for large loans like mortgages. When a mortgage lender sees a low DTI ratio, they’re more likely to consider the prospective borrower less of a risk and approve them. A borrower with a low DTI ratio doesn’t pay as much toward debts each month and has more income to spare toward a new payment, like a mortgage or car loan.
On the other hand, a high DTI ratio could be a sign that the borrower has a lot of debt compared to their monthly income and that they would have trouble taking on another monthly payment. In this scenario, it may be difficult to get approved for a loan, but if they do, they could face high interest rates.
When you keep your DTI ratio at a reasonable level, lenders will view you as someone who manages their debt well and will be comfortable approving you for additional credit.
What’s Considered a ‘Good' Debt-to-Income Ratio?
When you’re seeking credit, the less debt you have in relation to your monthly income, the better. According to Chase, keeping your DTI at or below 43% could keep you eligible for a qualified mortgage.
The further below that 43% threshold you can get, the better your chances of getting approval, however. A DTI ratio of 36% or less, for example, is a sign to lenders that you have a good amount of money left over after paying your obligations each month for savings and investments and that you wouldn’t struggle to repay a new loan.
If you fall into that 36%-41% DTI ratio range, lenders may still consider you a safe bet as your debt is manageable compared to your income. If you’re seeking a larger loan, however, lenders might want you to pay down some of your debt and lower your DTI ratio before they sign off on your approval.
As you inch up toward the 42%-49% DTI ratio, your debt starts to be seen as unmanageable in relation to how much you bring in each month. It only gets more difficult to get credit. Once your DTI reaches 50%, you’ll need to either lower your debt or increase your income before you can get approved for a loan.
How to Lower Your Debt-to-Income Ratio
Credit scores can be improved, and so can DTI ratios. If your DTI is at a higher rate than a lender feels comfortable with, here's what you can do to bring it back down and secure a loan:
- Pay off your current debt(s): As your debt decreases, the gap between how much you owe and what you earn increases, leading to a lower DTI ratio. Pay down your car loan, student loan, and credit card balance(s) as quickly as you can.
- Increase your income: Getting your monthly income higher than your debt can also improve your DTI ratio. Ask for a raise, find a side hustle, or look for a higher-paying job. Combining an increased gross income with less debt can quickly bring your DTI ratio within desirable thresholds that lenders find comfortable.
- Reprioritize your savings goals: Putting money aside for a down payment on a car or home is admirable, but those funds might be better served going toward lowering your DTI ratio. Reducing your debt can improve your DTI and, in turn, increase your odds of getting approved for a loan.
The Bottom Line
Whether you want to apply for a mortgage, car loan, or personal loan, your DTI (as well as your credit score) can be the difference between securing approval or not. Do what you can to keep your monthly debt low—that’s good to do at all times, but especially if you want to borrow money. And if you can continue to increase your monthly income as your debt dwindles, your DTI ratio will only become more attractive to lenders and improve your overall financial health.
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