What is a debt-to-income ratio?
And how you could lower yours to improve your chances of qualifying for credit.
In addition to your credit score, one of the main factors lenders look at when considering your loan application is your Debt-to-Income Ratio (or DTI ratio). DTI is a ratio, or percentage, that is calculated by dividing your total monthly debt payments by your total monthly income. While you may have a great credit score, your income is not a factor in your credit score calculation. Lenders want an additional way to gauge whether or not you will be able to afford the monthly payment for the new debt you are taking on.
What debts and income are included in your DTI ratio?
Not all of your monthly bills are included in a DTI ratio. Utility bills and money you spend on food or gas are excluded from your DTI ratio. Different lenders may use different debts to calculate your DTI.
Most lenders include the following types of payments in your DTI calculations:
- Mortgage or rent payments
- Home insurance payments
- Property tax payments
- Homeowners’ association fees
- Car payments
- Student loan payments
- Child support payments
- Alimony payments
- Minimum credit card payments
- Personal loan payments
If you are refinancing another loan, in some instances the lender will ignore the monthly payment of the loan being refinanced and calculate your DTI with the monthly payment of the new loan.
Income included in your DTI will include monthly income, before taxes, which you can demonstrate to the lender. This can include wages, commissions, bonuses, self-employment income, investment income, and child support or alimony received pursuant to a legal agreement. Generally, a lender will take the annual amount of all of your income and divide the number by 12 to arrive at your estimated monthly income.
How is DTI calculated?
Your DTI ratio is relatively easy to calculate and is just your monthly debt payments divided by your average monthly income. Here is an example:
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- Add up all of your annual income, including bonuses, investment earnings, etc., and divide by 12. If you earn $60,000 per year, your monthly income would be $60,000 divided by 12, or $5,000.
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- Make a list of all of your monthly debt payments. You can typically find these amounts by checking your monthly statements from each of your current lenders. Be sure to use the minimum monthly payment for credit cards, even if you pay extra each month. If you have a credit account that has no monthly minimum payment, lenders may choose to use a percentage (1-3%) of the current or original balance to estimate the monthly payment. Once you’ve collected the monthly debt payments, simply add them up.
- Divide the total debt payments by your monthly income. In this example, if your total monthly debt is $1,750, then dividing $1,750 by $5,000 gives you 0.35, or 35%. This is your DTI ratio!
How is DTI used?
Most lenders will set a maximum DTI limit to make sure you can afford your new loan. For example, a lender may have a DTI limit of 40%, and will calculate your DTI ratio as we did above, but will include the new loan payment in your monthly debt total to make sure you are not over the 40% limit.
To see what loan payment you can afford, simply multiply your monthly income by the lender’s 40% limit to get the maximum amount of monthly debt payments the lender will allow. In our example above the monthly income of $5,000 is multiplied by 40% to get $2,000. This is the total amount of monthly debt payments the lender will approve . We already have $1,750 in monthly debt from above, so this means you can afford an additional loan payment of $250 ($2,000 – $1,750).
What is a good DTI ratio?
Ideally, you want your debt-to-income level as low as possible when applying for a loan. Lenders typically look for DTI ratios lower than 40-50%.
How can I lower my debt-to-income ratio?
Since the DTI ratio is monthly debt payments divided by monthly income, to lower your DTI, you can lower your monthly debt payments or increase your monthly income, or both. Increasing monthly income is not an option for most people, so focus on your monthly debt payments.
Pay down credit card debt
The first place to start is credit cards. Most credit card lenders calculate the required monthly payment based on the outstanding balance on the card. If your credit card company adjusts the monthly payment based on the outstanding balance, then lowering the balance on your credit card will lower the required monthly payment and improve your DTI ratio. If you have outstanding balances on your credit cards, paying those down is the easiest way to improve your DTI. Doing so will likely improve your credit score at the same time!
Don’t take on new debt
Adding new debt may increase your monthly payments and will increase your DTI ratio. So unless you are refinancing existing debt, try to avoid large purchases or opening new credit accounts. Focus on paying down your high interest credit cards and other debts. Delay major purchases and avoid taking on debt for purchases that you don’t need.
Reconfiguring your debt may be an option
If you have good credit, but want to improve your DTI ratio, reconfiguring your existing debt can result in a lower monthly debt payment. Refinancing your home, car or student loans can help lower your monthly payments if you are able to qualify for a lower interest rate. Extending the term of a loan can also lower the monthly payment of debt, but be careful! Extending the term on a loan will often lead to you paying more interest over the life of the loan. Keep in mind refinancing some loans may entail fees and other costs, especially when you refinance a mortgage loan, so consider refinancing options carefully.
In addition to refinancing loans at lower rates, debt consolidation loans are available, allowing you to pay off one or more debts such as credit cards. These are typically personal loans, and may have higher interest rates than home loans, auto loans, or student loans. But, if you have several credit cards with high interest rates, consolidating these can still save you money and can lower your monthly debt payments. This strategy can be a good idea if you are committed to not running the balances back up on credit cards and avoid taking on new debt that you do not need.
Keep in mind that while refinancing debt can improve your DTI ratio, it also has the potential to lower your credit score. In addition to the small hit your credit score will take from a hard credit inquiry, if you completely close the account that you are refinancing (such as a home or car loan), the average age of your credit accounts may decrease, which can also temporarily lower your credit score.
It takes time, but you can start today!
Like improving your credit score, improving your debt to income can take a bit of time, but there are steps you can start taking today that will improve your debt to income ratio and help you qualify for loans when you really need them.
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