Debt to Income Ratio Explained

If you’re trying to take out a loan or a mortgage, you’ll inevitably run into the term “debt-to-income ratio” or DTI. Lenders use this important number to determine whether or not you’re a good candidate for a loan, and it can also help you get an idea of how much debt you can comfortably handle.

The best way to tell how much debt you can afford is to look at your debt-to-income ratio.

Understanding and managing your DTI is important for maintaining good financial health and improving the chances of obtaining credit on favorable terms in the future.

But what is the debt-to-income ratio, exactly? 

What is DTI?

The debt-to-income ratio is a percentage of how much total debt you have compared to how much money you make. It’s not just about how much you owe but also about how much money you make. 

Your debt-to-income ratio is an important number because it’s one of the factors lenders look at when determining whether to give you a loan. Lenders often look at your debt-to-income ratio when considering you for a loan because it helps them determine whether you can manage additional monthly payments and how likely you are to repay a loan on time.

That’s why it’s good to know what yours is before you apply for a mortgage or other type of loan. A higher debt-to-income ratio means you’re dedicating more of your budget to debt payments, which can make it harder to qualify for a loan or get a favorable interest rate. 

How to Calculate Your DTI

Debt-to-income ratio is the percentage of your gross monthly income (before taxes) that goes towards payments like rent, mortgage, credit cards, car loans, student loans, or other debt. This also includes payments for alimony, child support, and HOA fees.

Things like gas for your vehicles, health insurance premiums, utility payments, clothing, money going into savings or retirement accounts, and groceries typically aren’t included in your DTI.

There are tons of DTI calculators available on the internet, but follow these steps if you want to calculate manually.

1) Determine your total monthly income before taxes.

2) Add up all of your bills, not including groceries, utilities, and gas.

3) Divide the total sum of your monthly bills by your total before-tax income.

4) The result is your debt-to-income ratio.

For example, imagine your total pre-tax monthly income is $4000. You pay $1000 per month for rent, $500 per month for car payments, $100 per student loan, and $100 per month for credit card payments. Your total monthly debt would be $1700 ($1000 + $500 + $100 + $100). Divide 1700 by 4000, and you get a debt-to-income ratio of 0.425 or 42.5%.

What’s Considered a Good Debt-to-Income Ratio?

Generally, a debt-to-income ratio of 35% or less is ideal, but ratios of up to 50% may be acceptable for some borrowers. However, many lenders tend to adhere to the following principles:

• Acceptable DTI – 35% or less: You are doing pretty well. Although you have debt, your income is high enough to manage it. You should have enough left to save or spend after you pay your monthly bills. Lenders will usually approve a loan with a low DTI ratio.
• Room for Improvement – 36% to 49%: Opportunity for improvement. You’re doing great with your current debt-to-income ratio, but you may want to consider lowering it even further. 
• Too High – If you have a 50% debt-to-income ratio or higher, you may want to consider a plan to reduce your debt. A DTI ratio this high can limit your borrowing options.

How to Improve Your Debt-to-Income Ratio

One way to improve your debt-to-income ratio is to reduce your expenses. This might involve cutting back on unnecessary luxuries or negotiating better terms with your creditors. 

Another way to improve your debt-to-income ratio is by increasing the amount you can pay toward your debts each month. You can do this by making higher payments, refinancing your loans, or using a debt consolidation loan to pay off your debts in full. And be sure not to take on any new debt.

Finally, you can improve your debt-to-income ratio by increasing your income. This can be done by taking on extra work, starting a side hustle, or investing in assets that generate passive income. 

Final Thoughts

Since your debt-to-income is a factor for indicating how responsibly you manage your debts, it’s important to keep it as low as possible. Having a high DTI can result in paying higher interest rates on a loan or can result in you being turned down for a loan altogether.