A good debt-to-income ratio is key to loan approval, whether you’re seeking a mortgage, car loan or line of credit. This ratio shows lenders how much debt you have compared with how much income you earn.
“DTI ratio is the relationship between your scheduled monthly payments and your gross monthly income, expressed as a percentage,” says credit expert John Ulzheimer, formerly of FICO and Equifax.
The bottom line: Your DTI ratio helps a lender determine whether you can afford a new loan payment.
Read on to learn more about how to calculate DTI, why you need a good DTI and whether yours makes the cut.
What Is a Debt-to-Income Ratio?
Your DTI ratio is a snapshot of monthly debts versus earnings.
Included in your debts are mortgages, car loans and credit cards but not expenses such as rent, utilities, day care and car insurance.
What counts as income in your DTI ratio? The DTI calculation uses your gross monthly income, or the amount you earn each month before taxes and other deductions. Sources of income can include wages, salaries, tips and bonuses, pensions, and Social Security payments.
Child support and alimony count as debts if you’re making these payments and income if you’re receiving them.
Why Is Your Debt-to-Income Ratio Important?
Your DTI is important because it tells lenders whether you responsibly manage debt, and a low DTI ratio can put you in a good position to take on new debt.
Mortgage lenders use DTI to calculate how much home you can buy and whether to approve your loan, says Dave Krichmar, a Houston mortgage banker.
A lender may have concerns about your ability to pay for a new loan if you’re grappling with higher debt payments than you can comfortably afford. When your DTI ratio is too high, lenders aren’t likely to approve you for credit because they know you’re overextended and less likely to reliably pay.
How to Calculate Debt-to-Income Ratio
You can calculate your DTI ratio in four steps:
1. Add up your monthly debt payments.
2. Figure out your gross monthly income. If your income varies, estimate a typical month’s earnings.
3. Divide your total monthly debt payments by your gross monthly income.
4. Multiple your answer by 100 to get your DTI ratio as a percentage.
Let’s say your gross monthly income is $7,000 and your debt is $3,000: payments of $2,000 for a mortgage, $500 for a car loan, $300 for a student loan and $200 for a credit card. Monthly debt obligations of $3,000 divided by gross monthly income of $7,000 is 0.429. Multiply by 100 to get 42.9%, or a DTI ratio of 43%.
If you’re seeking a mortgage, use your potential new mortgage payment to calculate your DTI. If you are replacing your mortgage with another loan, do not add your old payment to your new one.
The Consumer Financial Protection Bureau has a DTI calculator that can help you simplify your math. If you’re not confident in calculating your DTI, you can also ask for help from an expert, such as a mortgage broker or loan officer, Krichmar says.
Getting confused or looking at the wrong numbers is easy to do, he says. For example, clients have incorrectly used their take-home pay instead of gross income to calculate DTI, Krichmar says.
What Is a Good Debt-to-Income Ratio?
When it comes to DTI, the lower the ratio, the better, Ulzheimer says. “It means you can take on new debt more easily because you have the capacity to make the payments,” he says.
A good DTI ratio is 43% or less, Krichmar says. How do lenders view your DTI ratio?
- 35% or less: Your score is solid. You most likely have money left after you’ve paid your bills.
- 36% to 49%: You have room to improve. You’re managing your debt OK, but a financial emergency could spell trouble. A lower DTI could put you in a better position to borrow or to handle unforeseen circumstances.
- 50% or more: You have work to do. If more than half of your income goes toward debt payments, then money is tight. Your borrowing options may be limited because you can’t afford new debts.
How to Lower Your DTI Ratio
To lower your DTI ratio, “You either reduce your monthly obligations, increase your gross monthly income or a combination of both,” Ulzheimer says.
The easiest way to decrease your monthly debt burden is to pay down high balances and pay off other balances, says Janice Horan, vice president, Fair Isaac Advisors Global Credit Lifecycle Practice at FICO. “The other way is to ensure that you’ve included all sources of income or to make sure that you have included any recent income increases,” Horan says.
Krichmar says you can lower your DTI ratio by paying more toward your credit card debts or refinancing loans to reduce your monthly payments.
Other actions that can move your DTI ratio in the right direction:
- Avoid taking on more debt. New debt can increase your DTI ratio unless you grow your income.
- Choose a strategy for paying off debt. Debt snowball or debt avalanche methods can be helpful, but they are not your only choices. You might consider a debt consolidation loan, balance transfer card or debt management plan, depending on your financial situation. Whatever you do, always pay more than the minimum on your credit cards.
- Look for ways to increase your income. Ask for a raise if you’re overdue for one, or consider picking up a side job.
Does Your DTI Ratio Affect Your Credit?
Your DTI ratio never affects your credit report or credit score.
“The DTI ratio is not included in the FICO score, as verified income is not an available field in the credit bureau files that form the basis of the FICO score calculation,” Horan says.
Generally, lenders see borrowers with higher DTI ratios as riskier than their peers with lower DTIs, Horan says.
Lenders may reject your loan application if your DTI ratio is too high, or you could end up with a low loan limit and a high interest rate.
If you have maxed out credit cards or high balances, those affect your DTI ratio and your credit score, Krichmar says. But “your credit score doesn’t know how much you’re making,” he says.
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