Debt-to-Income Ratio: What It Is and How to Improve 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 another payment (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 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 usedto determine how much money you can afford to responsibly borrow.
- Monthly debt obligations include recurring debt payments such as credit cards, car loans, student loans, and personal loans, in addition to your current rent or home mortgage payment. (Cable, phone, utility bills, and things like gym memberships, are not included in the calculation. And, 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, or net income (the amount after taxes, contributions to health insurance, 401(k), and the like are taken out).
> 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, worse, get your loan application rejected.
How is debt-to-income ratio calculated?
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 aren’t 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. 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 you any additional debt could become unmanageable, and, they may not offer you a loan.
> 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. Even a small amount will help decrease your overall debt, and as a result, lower your DTI ratio.
- 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 date 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.