Much like your credit score, the debt-to-income ratio is a number banks use to assess your borrowing power. While a credit report (and the resulting credit scores) are based on your history of buying things on credit and paying off debts, a debt-to-income ratio works more like a snapshot: A quick financial picture that tells lenders how much debt you have, how much money you make, and how much more debt you might be able to afford.
Just the way you regularly check your
credit score and understand your
credit utilization ratio, it’s also good to have a rough idea of your debt-to-income ratio, and know how to calculate it when you need to. Here’s everything you’ll want to know about debt-to-income ratios — and why it’s important to maintain yours.
What is a debt-to-income ratio?
Debt to income ratio (DTI) is a simple calculation that allows banks to determine your borrowing power. The reason it’s such a helpful number is that it's based on your total amount of monthly debts and your monthly income. When put into the proper equation, this delivers a number that quickly explains how much of your income is being
eaten up by current debt payments.
For this reason, banks typically like to see debt-to-income ratios below 43%. This is considered by many mortgage lenders to be the absolute highest DTI they’ll accept for new borrowers because it still leaves a substantial amount of your income available (in theory) to pay off new debts. For example, most lenders require a maximum of 43% DTI for FHA loans.
Some lenders, particularly those considering you for a qualified mortgage, may even prefer a DTI lower than 36%. While many small lenders won’t approve borrowers with DTI ratios over 43%, some larger banks will. That’s why it’s important to understand exactly what goes into calculating your DTI — so you can make an informed decision about how much debt you can afford, without relying solely on any calculations made by a lender.
Types of debt-to-income ratios
There are two different kinds of DTI to be aware of. The first is called a
front-end ratio, or housing ratio. This one is used primarily by mortgage lenders to see how much of your monthly income goes towards housing expenses. This includes things like your mortgage payment, homeowners insurance, and property taxes.
The second kind of DTI is called a back-end ratio. This one is a more in-depth look at your finances that determines how much of your income goes towards all of your monthly debts (including things like any student loans, auto loans, or child support), plus the previously mentioned housing costs. Although slightly different, both kinds of DTIs rely on the same basic formula, which I’ll dive into next.
How to calculate your debt-to-income ratio
DTI is calculated by dividing your total monthly debt payments by your gross monthly income. Gross monthly income means how much money you earn before taxes and other deductions are taken out. You should be able to find this information on a recent pay stub if you don't already know it.
As far as calculating total monthly debt payments, keep in mind that for most people, debt payments come from multiple places. For example, you may have a monthly car loan payment,
student loan payments,
mortgage payments, and even
credit card payments that all go into calculating your monthly debt total. Even things like child support may count as debt, depending on the type of loan you’re applying for. While you likely have other monthly bills, these are not necessarily part of your debt total. Your debt total encapsulates all of the money that you’ve borrowed — so while a monthly
mortgage payment is considered debt, rent payment isn’t.
Let’s take a look at an example of a DTI calculation.
Example: Jack’s DTI
2,100 divided by 700 is 0.33, meaning Jack’s DTI would be 33%. If however, Jack also had an additional $245 monthly credit card bill to pay off — putting his monthly debt total at $945 — he would now have a DTI of 45%, which is too high for a small lender to consider him as a new borrower.
How does your DTI affect you?
Again, DTI is a ratio used by banks and other lenders to determine your ability to take on new debt. Although it’s by no means the only thing lenders look at, having a high DTI will make it harder for you to get approved for any new financing. This includes things like getting an auto loan, taking out a new credit card, or even
getting approved for a new mortgage.
On the flip side, having a lower DTI can help
increase your credit score, which can unlock a lot of doors. If you’re in the process of home buying, a lower DTI (and higher credit score) could help you secure more competitive mortgage rates. If you’re simply in the market for a new credit card, the lower DTI might help you get approved for a card with higher credit limits.
For all of these reasons, it’s a good idea to know roughly what your DTI is before applying for any new financing, and also be prepared to improve it if your number is too high.
Ways to keep your DTI low
Because there are only a few numbers involved in calculating your DTI, there’s also a finite list of ways you can improve it. Here are some of the major ones to consider if you find your DTI is too high.
Reduce your debt
One of the fastest ways to lower your DTI ratio is by
reducing your amount of debt. Start by making a plan to pay down a portion of your debts faster. This might be as simple as making above minimum credit card payments or even paying down part of your other loans in a lump sum. Whatever you can do to lower your debt, the better off your DTI will be.
Avoid new bad debt
Another relatively easy way to maintain your DTI is to avoid taking on any new “bad debt.” Bad debt is defined as things like credit card debt or personal loans, or any other kind of consumer debt that doesn’t increase your wealth in the long term. Good debt, on the other hand, includes things like student loans, mortgages, and other investments that may increase your wealth.
If your DTI is higher than you’d like it to be, now is not the time to borrow more money — especially the kind that ultimately won’t improve your finances. You can avoid taking out new debts by
coming up with a budget and creating a savings plan to help afford any major expenses that come along.
Increase your income
If paying down your debts isn’t an option, you might consider improving your DTI by increasing your income. This might mean approaching your boss and asking for a raise, looking for new jobs, or even
starting a lucrative side hustle.
Consider a debt consolidation loan
While this won’t directly lower your DTI, it might make paying down your debts easier. Much like other forms of refinancing,
debt consolidation loans are a helpful tool for anyone with high-interest debt that’s become unmanageable. By consolidating all of your debt into one place (ideally at a lower interest rate), you’ll be able to make faster progress paying it back.
The bottom line
Keep in mind that your total monthly debt probably doesn’t tell the full story about your finances. For example, you might have additional expenses (like rent, groceries, health insurance payments, alimony, etc.) that you’re responsible for that aren’t considered by the bank to be “debt.”
For this reason, it’s important to always look at the full picture of your finances when deciding how much more debt to take on. Don’t just rely on a lender to do this for you. Instead, spend some time calculating just how much debt you can realistically afford within your current budget. That way, if you do decide to borrow a new loan, you’ll know for a fact that you can pay it back.
