What is Debt-to-Income Ratio? (And How to Calculate It)
When you apply for a loan or line of credit, lenders compare your debt-to-income (DTI) to help make well-informed approval decisions and to determine whether or not you can responsibly afford to take on more debt. When it comes to your overall financial health, your debt-to-income ratio is just as important as your credit history or job stability.
What is debt-to-income ratio?
Your debt-to-income ratio compares your total monthly debt obligations (how much you owe) to your monthly gross income (how much you earn before taxes). Your DTI ratio gives lenders a clearer picture of your current debt and income, and is used to determine how much money you can afford to responsibly borrow.
- Monthly debt obligations include recurring debt payments such as credit cards, car loans, and personal loans, in addition to your student loan payments, and your current rent or home mortgage payment. Cable, phone, utility bills, and things like gym memberships, are not included in the calculation. While you’re not required to provide child support or alimony payments, including these can improve the accuracy of your DTI.
- Monthly gross income is how much you are paid before taxes are deducted. Note that gross income is not the same as your take-home pay, also known as your net income (the amount after taxes, contributions to health insurance, 401(k), etc., are taken out).
> Pro Tip: Be as accurate as possible when reporting your income to lenders, and don’t forget to include any income from bonus or overtime pay. Most lenders verify income during the loan application process, so if your numbers are different from theirs, it can delay the process, or cause your loan application to be declined.
How to calculate debt-to-income ratio?
Generally, your DTI ratio is calculated by adding up your total recurring monthly debt (including the monthly payment amount of the loan you’re applying for) and dividing it by your gross monthly income.That number is turned into a percentage to come up with your DTI ratio.
For example: If your monthly debt payments are $1,000 and your gross monthly income is $5,000, your debt-to-income ratio is 20%.
Why is debt-to-income ratio important?
Lenders will not approve a loan application if they are not confident in your ability to repay. That’s why your debt-to-income ratio is one of the most important measurements (along with credit history) lender’s use in the loan application process. A high debt-to-income ratio can prevent you from qualifying for a loan, or higher interest rates. If you need a loan now, or hope to obtain one in the future, your debt-to-income ratio will play a significant role in the lender’s approval decision.
How DTI impacts your ability to get a loan
Your debt-to-income ratio directly impacts your ability to secure a loan. A low debt-to-income ratio (under 40%, typically), signals a healthy balance between debt and income. Lenders like seeing low debt-to-income ratios because it is an indicator you are more likely able to successfully manage additional debt responsibly. The lower your DTI, the more likely you are to receive a loan.
In contrast, a high debt-to-income ratio (anything above 40%, usually) indicates you may already have or are about to take on more debt than you can reasonably handle given your current income. A high DTI ratio signals to lenders that extending additional debt could become unmanageable, and, they may not offer you a loan.
> Pro Tip: Most lenders do not advertise maximum debt-to-income ratios, but guidelines that offer some flexibility. For example, a common rule of thumb is the 28/36 Rule used by some lenders to assess borrowing capacity.
How to improve your debt-to-income ratio
Like your credit score, there are ways to improve your debt-to-income ratio. If your current DTI ratio is over 40% (or hovering close) here are some ways to improve it:
- Pay down existing debt. Increase the amount you’re currently paying on your monthly debt, i.e. rather than making the minimum credit card or loan payment every month, pay off slightly more. Even a small amount will help decrease your overall debt, and lower your DTI ratio as a result.
- Avoid additional debt. Focus on paying down your current debt without adding more recurring debt obligations.
- Postpone large purchases. If possible, avoid making large purchases that will use up a large portion of your available credit.
- Create and stick to a budget. If you don’t already have one, create a personal monthly budget and stick to it. If you already have a budget, consider increasing your monthly debt payments and decreasing your overall spending to pay down your existing debt faster.
- Check your DTI ratio regularly. Make a note to recalculate your debt-to-income ratio on the same day every month. Note any changes, record your progress, and use it for motivation.
Debt-to-income ratio is an important measurement used in the loan application and approval process. Understanding what it is, and what you can do to improve it, may help enhance your overall financial health and increase your ability to secure a future loan.
Debt-to-Income Ratio FAQs
What is a good debt-to-income ratio?
Generally, most lenders consider at or below 36% a good debt-to-income ratio, though many will lend to individuals with a higher ratio. A DTI at or under 18% is considered excellent, while a DTI of 43% is the maximum debt to income a borrower can have for a qualified mortgage.
Is rent included in debt-to-income ratio?
Whether or not rent is included in debt-to-income ratio calculation depends on the type of loan you’re applying for. For a personal loan, any amount you pay toward housing such as rent counts toward your overall monthly debt and will be included in calculating DTI. When applying for a mortgage, your current rental or lease payment is not included in your debt-to-income ratio calculation.
How can I lower my debt-to-income ratio quickly?
The only way to quickly lower your debt-to-income ratio (besides getting a huge pay or salary increase) is to pay off more of your debt than the minimum required. There are a number of different strategies for paying off debt: the debt avalanche method will pay off debt the fastest, but look into the debt snowball and debt snowflake methods as well.