You’ve kept a stable job over the last few years and worked relentlessly to improve your credit. Now you’re prepared to submit that loan application. Or are you?
In supplement to your job history and credit, lenders will consider another major measure of financial health: debt-to-income ratio, or DTI. Learn more about what your DTI means, how you can calculate your debt to income ratio, what is included in the debt to income ratio, what is a good debt to income ratio and how can you improve your DTI ratio.
Table of Contents
- 1 What Is Debt-to-Income Ratio?
- 2 Types of Debt-to-Income Ratios
- 3 What Is a Good Debt-To-Income Ratio?
- 4 How Debt-To-Income Impacts Your Credit Score
- 5 How to Improve Your Debt-to-Income Ratio
- 6 Debt-To-Income Ratio for Car Loan
- 7 Mortgage-To-Income Ratio Calculator
What Is Debt-to-Income Ratio?
Your debt-to-income ratio is a tool lenders use to determine how much of your income contribute toward paying off debt every month. It considers all your monthly debt payments in contrast to your gross monthly income and is stated as a percentage.
When you apply to borrow money, lenders like to look at a low DTI. This is a strong signal that you have sufficient cash to make your payments on time every month. A low DTI is also a good indication that you’re in a strong place financially and can easily manage to pay for your
lifestyle—whether or not you intend to borrow.
How to Calculate Debt-to-Income Ratio
To calculate your debt-to-income ratio, start by adding up all your monthly debt obligations. This contains revolving credit, such as credit cards and other lines of credit, as well as installment loans such as student loans, car loans, and personal loans. You also must include any child support or alimony payments you’re liable for making each month. Generally, you don’t need to take into account other expenses such as food, utilities, and insurance.
Once you have all your obligations recorded, divide that number by your gross monthly income (that’s what you earn before taxes, retirement contributions, and other deductions are taken out). You’ll be left with a decimal fraction, which you can multiply by 100 to get your DTI percentage. The equation seems like this:
DTI = Monthly Debts / Gross Monthly Income
For example, say your debts are as follows:
- Credit Card A: $500
- Credit Card B: $350
- Auto Loan: $150
- Home Equity Line Of Credit: $200
- Student Loan: $400
That gives you a total of $1,600 in monthly obligations. Now suppose your gross monthly income is $5,000. You would calculate your debt to income ratio as follows:
$1,600 / $5,000 = 0.32
Multiply the result by 100 and you get a DTI of 32%. In other words, 32% of your gross monthly income goes toward paying back debt.
Remember that even if your DTI is seen as low, other monthly expenses can eat your budget. When borrowing money, it’s critical to see how these other costs could affect your capacity to stay on top of payments.
Monthly Debt Payments That Are Included in the Debt-To-Income Ratio:
- Monthly credit card payments (you can use the minimum payment when calculating your DTI ratio)
- Monthly mortgage payment (including insurance, taxes, HOA payments)
- Monthly car payment
- Monthly student loan payments
- Monthly personal loan payments
- Monthly debt consolidation loan payments
Income Included in Your Monthly Income When Calculating Debt-To-Income Ratio:
- Income from wages, salary
- Income from tips, if applicable
- Income from self-employment (make sure it is verifiable via tax return)
- Income from alimony
- Income from child support
- Income from Social Security
- Income from a pension
- Disability income
- Income from investments such as rental properties, stock dividends, and bond interest (must be documented on tax returns)
Monthly Payments Not Included in the Debt-to-Income Ratio:
Many regular monthly bills should not be included in your debt-to-income ratio because they are deemed as fees for services and not accrued debt. These usually contain routine household expenses such as:
- Monthly utilities, including garbage, electricity, gas, and water services
- Paid television (cable, satellite, streaming) and internet services
- Car insurance
- Health insurance and other medical bills
- Cell phone services
- Groceries/food or entertainment costs
- Childcare costs
Types of Debt-to-Income Ratios
Normally, the equation given above gets you your general debt-to-income ratio. Nevertheless, some lenders like to break this number down even further to get your front-end and back-end DTI. You’ll frequently come across these terms when requesting a mortgage.
Front-end DTI measures your housing costs or possible housing costs only in relation to your income. Also termed as the housing ratio, this computation takes into account your monthly mortgage payment, private mortgage insurance, and other costs related to your home loan, divided by gross monthly income.
Back-end DTI is the more thorough calculation. This version of DTI not only looks at your housing expenses but all debt obligations such as credit cards and loans, divided by gross monthly income.
What Is a Good Debt-To-Income Ratio?
There is no one answer when it comes to what is a good debt-to-income ratio. Instead, it is based on a multitude of factors, including your lifestyle, goals, income level, job stability, and forbearance for financial risk.
But there are common rules of thumb to adhere to when deciding whether your ratio is good or bad:
- DTI from zero to 35%: Lenders see this range as a sign of stable finances and capacity to repay debt. Wells Fargo, for example, categorizes a ratio of 35% or lower as indicating a “manageable” debt level comparative to your income, where you “most likely have money left over for saving or spending after you’ve paid your bills.”
- DTI from 36% to 43%: While you may still be handling your debt effectively, you are at increased risk of coming up short should your financial condition alter. To use a health comparison, while your debt level may not be classed as obese, you could benefit from some healthier financial-fitness habits. You still might be able to meet the criteria for most loans, including mortgages, but you have little room for mistakes. For that reason only, you should look for prospects to get your debt-to-income ratio in better shape.
- DTI from 44% to 50%: While you may still be eligible for smaller loans, you will have a tough time securing a mortgage once your debt-to-income ratio surpasses 43%, though there have been recent attempts to relax that standard. If you’re in this category, now is the time to think about registering in a debt management plan or other debt relief program to enhance your ratio and increase your credit-worthiness.
- DTI over 50%: This is normally deemed as an unhealthy level of debt for most households and should be seen as a warning sign to start working on lowering your debt burden immediately. At this ratio, you will have difficulty meeting the criteria for most loans and are at threat of financial crisis should your expenses soar or income decline. If your debt-to-income ratio is over 50%, you’d be well-recommended to explore credit counseling and/or consolidating debt payments.
How Debt-To-Income Impacts Your Credit Score
Not only does your DTI affect your ability to obtain a loan, but it also implicitly affects your credit. That means even if you aren’t seeking to borrow money right now, a DTI that’s too high could knock points off your credit score and make it harder to get an apartment or open a utility account.
The major reason DTI and credit are related is for the reason that the total amount of debt you owe affects roughly 30% of your FICO score. The lower the amount of debt you owe in relation to your available credit, the better your score. On the contrary, the more debt you have to your name, the worse its effect on your score. Therefore, if you have a high DTI, it entails that you are perhaps using a considerable part of your available credit.
DTI also can impact your credit if you owe so much that you are unable to keep up with payments. As the most heavily weighted factor in determining your credit score, payment history makes up 35%. Just one missed payment can knock quite a few points off your score, so it’s crucial to keep your debt levels controllable.
How to Improve Your Debt-to-Income Ratio
The goal is generally 43% or less, and lenders often advise taking remedial steps if your ratio surpasses 35%. There are two alternatives to enhancing your debt-to-income ratio:
- lower your debt
- increase your income
Neither one is simple for many people, but there are tactics to consider that might work for you.
Lower your debt payments
For most people, tackling debt is the easier of the two solutions. Begin by creating a list of everything you owe. The list should involve credit card debts, car loans, mortgage and home-equity loans, homeowners association fees, property taxes, and expenses like internet, cable, and gym memberships. Sum it all up.
Then see your monthly payments. Are any of them bigger than they need to be? How much interest are you paying on the credit cards, for example? While you may be rejected for a debt consolidation loan because of a high debt-to-income ratio, you can still go in for a debt consolidation alternative: nonprofit debt management. With nonprofit debt management, you can combine your debt payments with a high debt-to-income ratio because you are not taking out a new loan. You still will be eligible for lower interest rates, which can lower your monthly debt payments, therefore lowering your ratio.
Keep in mind that improving your DTI ratio depends on debt payments and not debt balances. You can lower your debt payments by discovering a debt solution with lower interest rates or a longer payment schedule.
Other options worth considering to lower your expenses and pay off debt:
- Cancel your cable subscription or choose a cheaper plan to cut your monthly costs. Then look for ways to save money on your cell phone bill. Can you shift to a cell-phone plan that consumes less data and costs less?
- Put off large purchases until you have more cash. The more cash you can use to purchase, the less you must borrow, so open a savings account to assist in paying for big-ticket items such as cars and vacations.
- If you have student loans, the bane of the Millennial generation, find out if you can get a lower required payment. Lenders use your required minimum debt payment to reach an income-to-debt ratio, so the lower the required payment, the good your debt to income ratio will be. Normally, nothing stops you from making larger payments if you have extra cash — that’s not the concern here.
- Refinance loans if it seems logical. Interest rates have plummeted significantly since the Great Recession and remain low. Check with a lender to see if refinancing, which might include upfront costs, makes financial sense.
- Alter your shopping habits. Think about shopping for groceries at big-box retail stores like Walmart or Costco. See if you can repair, rather than replace, tired appliances. Attempt to keep your old car running for another year or two and dodge the desire to buy the fashion-forward clothes when the slightly dated ones will do.
- Sell unwanted stuff on eBay or Craig’s List and apply the proceeds to your debt payment plan.
- Don’t purchase on impulse. If anything is sure to weaken your strategy, it’s needless feel-good purchases.
Most crucial, make a realistic budget intended to lower your debt and adhere to it. Once a month, recalculate your debt-to-income ratio and see how fast it drops under 43%.
Increase Your Income
Improving the income side nearly always is more tricky because it involves the one thing no one has enough of – time. Finding a night-time or weekend job that generates even a couple of hundred dollars could play a vital role in getting your debt-to-income ratio below 43%.
Here are some avenues to increase your income:
- Ask for a raise at work
- Start a small business
- Promote your skills on Craigslist: house cleaning, handyman work, babysitting.
- Start driving for Uber or Lyft.
- Flip furniture or other goods: buy at garage sales and flea markets, sell on eBay and Amazon.
- Mow lawns, shovel snow, pick up holiday shifts.
- If you’re a stay-at-home spouse, watch other people’s kids too.
- Offer rides to the airport from your town for a fixed price. Advertise on a community Facebook board.
Finding a blend of the two – part-time job, plus reducing expenses – is the best solution and might even bring your debt-to-income ratio below the 36% level that lenders are eager to do business with. If working extra hours doesn’t attract you, keep in mind – this is just temporary. You can make use of the income to pay off debt, lowering your ratio and your need to work extra.
Debt-To-Income Ratio for Car Loan
As a credit-challenged car buyer, it can be difficult to know just what a lender is considering when you apply for a car loan. Lenders that can assist in this situation typically have many conditions to be met, and one of the most crucial is your debt to income (DTI) ratio.
Your DTI ratio compares your bills to your monthly income. Lenders use this to decide if you have sufficient available income to consistently and easily make your car loan payment. For credit-challenged consumers, lenders generally need that your debt to income ratio for a car loan is no more than 45% to 50%, including the approximated vehicle and insurance payment. Lenders that work with bad credit borrowers don’t need you to go broke paying for a car. This is one of the grounds that they calculate your DTI ratio every time you apply for a car loan.
Your DTI ratio is just one element they take into account, though. Before you can get to this step, lenders first require a minimum income. The amount that makes you eligible varies from lender to lender, but you’re typically required to make at least $1,500 to $2,000 a month before taxes from a single source.
Mortgage-To-Income Ratio Calculator
Your debt-to-income (DTI) ratio and credit history are two critical financial health factors lenders take into account when deciding if they will lend you money.
To compute your estimated DTI ratio, simply insert your current income and payments in the mortgage to income calculator to quickly get an idea of how much your income contributes to paying off your debts.