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An Overview of Debt-to-Income Ratio
Your debt-to-income ratio is an indicator of your financial wellness.
Your debt-to-income ratio (DTI) is an important metric lenders use when reviewing applications for different lines of credit and loans, particularly home loans. While lenders also review other details of your finances during the application process, such as your credit score and credit report, your DTI plays a significant role when it comes to the amount you may be approved for.
Before you apply for your next loan or line of credit, let’s dive deeper into how to calculate your debt-to-income and the impact it may have on your finances.
Key Takeaways
Your debt-to-income ratio shows how much debt you have compared to your gross monthly income.
The ratio includes your total debt payments, housing costs, and loan payments, but doesn’t take utility bills, grocery expenses, or healthcare costs into consideration.1
Experts recommend trying to keep your DTI below 43%, but ratios at 36% or lower may help you qualify for even lower rates.2
What Is Your Debt-to-Income Ratio?
Your debt-to-income ratio compares your monthly debt obligations against your gross earnings (meaning before taxes and deductions are taken out).3
Debts in this ratio include the minimum required payments for the following financial obligations:4
Mortgages/rent payments
Homeowners’ association dues
Auto loans
Student loans
Credit cards
Personal loans
Alimony/Child support
When calculating your income, be sure to include all sources, such as:5
W2/1099 income
Investment dividends
Alimony
Why Is DTI Important?
DTI gives lenders a lot of information about your finances and your debt levels. A low DTI indicates to lenders that you’ve used debt conservatively relative to your income level. A low DTI may even help you secure lower rates or larger loan amounts.
A high DTI, on the other hand, may indicate that you’re overextending yourself and could have trouble making payments on any new loans or lines of credit. High DTIs may result in lower credit limits or loan amounts or higher rates if lenders approve your application.
Two Components of DTI: Front and Back-end Ratios
There are two parts to your DTI ratio: the front-end ratio and the back-end ratio. The front-end ratio, often referred to as the housing ratio, only takes into consideration your housing costs like:
Mortgage/rent payments
Insurance premiums
Homeowners’ association fees
Property taxes
The back-end ratio looks at all of your monthly debts including your housing costs, credit cards, student loans, etc.
How to Calculate DTI
Your debt-to-income ratio is expressed as a percentage and is simple to calculate. Start by totaling up your monthly obligations and debt payments listed above. Remember you don’t need to include things like utility bills or grocery costs.
Then, total up your monthly income from all sources. Once you have these numbers, you can calculate your DTI.
The formula looks like this: (Total monthly debts / Total monthly income) * 100.6
How does this look in real life? Let’s take a look at an example.
Say you have the following expenses:
A minimum credit card payment of $150
A mortgage payment of $2,200
Two student loans with a combined monthly payment of $400
A car loan with a payment of $470
Your total monthly debts come to $3,220.
You earn $8,500 per month in gross income from your employer and another $500 from your investments, bringing your total monthly income to $9,000. Your back-end DTI calculation would look like this: ($3220/$9000) * 100 = ~36%.
What Is a Good DTI Ratio?
Every lender sets their own requirements about what qualifies as a good DTI, but most prefer borrowers with DTIs of 36% or less.
What does this mean from a practical standpoint? DTI ratios tend to fall into three distinct bands that influence your loan or credit card applications. Here’s what you need to know.7
DTIs of 36% or less: Borrowers with DTIs of 36% or less are considered less risky borrowers. Lenders tend to reward borrowers with DTIs of 36% or less with lower rates and higher loan amounts or credit limits.
DTIs of 36% - 49%: Borrowers with DTIs between 36% and 49% may find it slightly more difficult to qualify for a loan or a new credit card. Depending on how high their DTI is, lenders may offer lower loan amounts or credit limits and higher rates than borrowers with lower DTIs would qualify for. They may also require borrowers to meet other eligibility requirements.
DTIs of 50% or above: Lenders are most hesitant to work with borrowers who have DTIs of 50 or above as ratios this high indicate borrowers have limited money to save or spend and may not be able to handle an emergency expense.
How DTI Impacts Mortgage Applications
When you apply for a mortgage, lenders look at your back- and front-end DTIs as they decide whether to approve your loan application. Typically, lenders want to see ratios of 36% or less and no more than 28% of your income going toward housing costs, whether they’re an existing mortgage or rent payment.8
The minimum DTI required also varies depending on the type of mortgage you’re applying for. For example, Federal Housing Administration (FHA) loans often allow for higher DTIs than conventional mortgages.
Tips to Lower Your DTI
If you’re looking to lower your debt-to-income ratio here are a few tips.9
Reduce Your Total Debt: Paying down or paying off outstanding debt lowers your DTI. Using the
debt snowball or debt avalanche method may help you pay off what you owe faster. Just remember that fully paying off a loan may cause a temporary drop in your credit score if the account closes.
Reduce High-rate Loan Payments: You may be able to refinance your mortgage, student loan, or auto loan to lock in a lower rate or switch to a longer term which could help you decrease your monthly payments.
Consolidate Credit Card Debt: If you’re carrying a balance on multiple cards, you may be able to use a debt consolidation loan to combine those balances at a lower rate or use a balance transfer with a low or 0% Annual Percentage Rate introductory rate. Either of these could help you pay off your principal faster and may even save you money on your interest payments over time.
Take on New Debt Strategically: The more debt you take on, the higher your DTI may be. If you think you may want to buy a house or even refinance your current home in the future, be mindful of your DTI and potentially avoid taking on smaller loans or increasing credit balances in the meantime.
Final Thoughts
Your debt-to-income ratio is an important factor when applying for loans and credit cards. By understanding how your habits influence your DTI, you’re able to take charge of your finances and find ways to keep your ratio as low as possible.