Debt-to-Income Ratio Explained
A debt-to-income ratio is one of the most important factors lenders use to determine whether or not you will be able to make your loan payments. It’s an indicator of how much income you have available after subtracting all monthly expenses, including housing costs.
The higher your DTI is, the more likely it is that you’ll struggle to make your loan payments on time each month which will lead to late fees and penalties, as well as possible foreclosure.
Understanding this balance and how it works is extremely important so you can watch out for signs that indicate whether or not this ratio is getting too high for comfort. If that is the case, it may be time to consider making some adjustments like taking on less debt in the future.
Debt to income ratio calculator takes into account your monthly debt payments and divides them by your gross monthly income. The resulting number will be somewhere between 0% and 100%, with higher percentages representing more debt or less available cash flow.
Let’s now dive into this topic even further so you can get a clearer picture of the significance it has on your everyday life.
What Is a Debt-to-Income Ratio?
Your debt-to-income ratio (DTI) is a measure of how much debt you carry compared to your income. Lenders use this measurement to determine how much of a loan amount you can qualify for and what kind of interest rate you’ll get, among other things.
This measure stands for your ability to repay debt. It’s calculated by dividing your monthly debt payments by your gross monthly income.
As a general rule, a good debt-to-income ratio is considered everything below 36%. So, for example, if a lender sees you have more than this percentage and little to no additional room for other expenses (like groceries and gas), they might decide not to extend credit to you at all though this is not always the case of course.
How Is the Debt-to-Income Ratio Calculated?
Now that you know what a good debt-to-income ratio is, let’s see how you can calculate it.
Debt-to-income ratio formula is a key factor in helping you determine how good your chances are of getting approved for a mortgage or any other type of loan.
So, once again here is how to calculate it yourself- take the total monthly debt payments and then divide it by your gross monthly income, and the number you got then just multiply by 100.
The debt portion of your DTI includes any monthly payments on credit cards, student loans, car loans, or other types of loans that require regular payments. The income portion includes any monthly income from wages and salaries as well as rental income and some investment interests.
This simple equation shows how much of your gross monthly income goes towards paying off the debts you owe each month (excluding taxes).
To further explain this, we will give you one example. Let’s say your monthly salary is $5,000 and your expenses come to around $2,900 once you calculate your rent, bills, car payments, etc.
So, by using the equation we provided you this is the calculation- 2,900/5,000 and that is equivalent to 58%
If this number is too high like the one above, your lender may decide that you won’t have enough money around once you pay off all of the bills and this is why they may deny your application accordingly.
Nonetheless, knowing this number is important because once you do, you can know exactly where you stand financially but also take the necessary steps to lower your percentage.
What Is a Good Debt-to-Income Ratio?
In general, a good DTI is considered to be anything below 36%. This is why knowing how to calculate debt to income ratio is important as you can check how you are doing and if your score is improving.
When calculating this ratio for yourself, make sure that you are factoring in all of your debts and all your sources of income to get the best estimate of the total percentage.
In case your debt-to-income ratio falls between 36% and 41% this will suggest that you have manageable levels of debt in relation to your income. However, larger loans or loans with strict lenders may like to see you pay down some of this debt to reduce your DTI ratio before you earn their approval.
Between 42% to 49% lenders may be hesitant to give you any loan, but this certainly does not mean all of them will reject you. And lastly, if your DTI level is above 50% you will likely be seen as someone who struggles to regularly meet all the financial obligations. You will also be asked to reduce your debt or increase your income before they feel comfortable providing you with a loan or line of credit.
For example, if you are trying to get a mortgage your debt-to-income ratio should not be higher than 36% if you are trying to get more of a conventional loan, but if you are opting for government-backed-up ones your ratio can be slightly higher.
This goes for any other loan as well, but if you are looking for those on the shorter-term side, the bank may be willing to work with you even if your score does not fall into this “perfect” category.
How to Lower Your Debt-to-Income Ratio
Once you get familiar with your score, you can see where you currently are vs where you ideally want to be. There are several ways you can reduce the overall debt you owe.
Here are some ways:
- Pay off high-interest debt first. There’s no point in paying off small balances at low-interest rates if those payments barely make a dent in your principal balance. Instead, focus on paying down the credit cards that charge the highest interest rate first.
- Pay more than the minimum payment amount on your credit cards. If you can afford more than just the minimum payment due each month on your card(s), it makes sense to do so. This will further decrease your balance much faster and save money in interest payments along with building up good credit by demonstrating responsible spending habits over time.
- Look into loan forgiveness. Depending on the loan type you have, you may be eligible for loan forgiveness which can help tremendously in improving your DTI score.
- Try to find an additional source of income. In case you are able to find another job or some other way to generate income this will reduce your score and enable you to have some cash flow.
- Look into consolidating loans or refinance plans through another lender who may offer better terms. This way, instead of having multiple loans from different lenders with varying terms and conditions attached to them, all of your debts would be rolled into one single loan with uniform terms and conditions attached. This could potentially lower overall monthly payments because each individual lender might be able to offer lower rates when bundled together rather than separately signed contracts negotiated independently by each one.
And lastly, just because you managed to improve your ratio does not mean that you should carelessly take on more debt in the future. Be very cautious when it comes to signing up for any additional monthly payments and avoid it if you can.
Does the Debt-to-Income Ratio Affect Credit?
The DTI is a common tool used by lenders to determine whether a borrower can afford the payment. In order to qualify for any loan, you must have a high enough credit score and a low enough debt-to-income ratio. If your DTI is too high, then it’s likely that you will not qualify for any loans or other types of credit products such as credit cards.
This ratio doesn’t directly impact your credit score because this measure isn’t used to calculate your credit score. But that does not mean that you should not pay attention to it because it still is a big factor lenders use to decide whether to lend to you any money as it indicates are you able to take on an additional financial obligation.
If your DTI is too high, you may need to find ways of reducing it before applying for any new types of financing. Even if your credit score is in the good or excellent range, your debt-to-income ratio for a mortgage shouldn’t be above 40% for lenders to even consider you as a candidate.
A good credit score and low DTI are the ultimate indicators of your trustworthiness as a borrower.
So, while you were always told to keep your credit score in check so the lenders will look favorable on you and give you a loan, you may never have heard how important keeping your DTI in check might be for this same purpose.
Why Is Debt-to-Income Ratio Important?
Lenders want to know you can pay them back, so there are many measures created as a sort of tool they can use to minimize their risks.
Your DTI is an important factor in determining how many more obligations you can afford to take on. The higher your DTI, the more likely it is that you are going to default on your payments and end up being a huge burden for the lender. As a result, they may refuse to grant you a loan if they don’t feel comfortable with the amount of debt you’re currently handling.
Here’s why: If your percentage is too high, then it means that there’s not enough money left after paying all of your bills each month. When this happens, there won’t be any extra funds available for other deposits or repairs—and this can lead to financial problems down the road! Lenders don’t want to just speculate if you will pay your monthly installment to them.
The debt-to-income ratio is an important measurement for determining if borrowers can afford their payments. When used in conjunction with other financial ratios, it can help you determine if you are ready to take on a new loan.
If your DTI is above 36%, you may want to consider paying down some of your debt before applying for a mortgage or any other longer-term loan of a similar kind.
In this article, we gave you a good explanation of what debt to income ratio is and how to improve it, but the rest is on you. Be sure you are keeping this number in your head the same as your credit score as it can be equally important. In case you need any additional help in further understanding the relevance of this topic in regard to your personal financial situation, we suggest you hire an experienced financial advisor.