If you’ve recently been in the market for a mortgage loan, you may have come across the term “debt-to-income ratio.” This ratio is one of the many factors lenders use when considering you for a loan.
But what is a debt-to-income ratio?
A debt to income ratio (DTI) is the percentage of your gross monthly income that goes to debt payments. Debt payments can include credit card debt, auto loans, and insurance premiums.
How to Calculate DTI
In order to figure your debt-to-income ratio, you need to determine your monthly gross income before taxes. This must include all sources of income you may have.
Next, determine what your monthly debt payments are. If you’ve already created a budget, this should be easy. Be sure to include credit cards, auto loan, mortgage, and so on.
The final step in calculating your debt-to-income ratio is to divide your total monthly debt payments by your monthly income gross. To get a percentage, move the decimal point over to the right two times.
Here’s an example of a debt to income ratio formula calculation:
Mortgage: + $1100
Auto loan: + $300
Credit card payments: + $200
Monthly debt total = $1600
Monthly income gross / $4200
1600 / 4200 = .3809
0.3809(100) = 38.09
Debt ratio = 38%
What is a Good Debt-to-Income Ratio?
Generally, an acceptable debt-to-income ratio should sit at or below 36%. Some lenders, like mortgage lenders, generally require a debt ratio of 36% or less. In the example above, the debt ratio of 38% is a bit too high.
However, some government loans allow for higher DTIs, often in the 41-43% range.
Why is Your Debt-to-Income Ratio Important?
A DTI is often used when you apply for a home loan. Even if you’re not currently looking to buy a house, knowing your DTI is still important.
First, your DTI is a reflection of your financial health. This percentage can give you an idea of where you are financially, and where you would like to go. It is a valuable tool for calculating your most comfortable debt levels and whether or not you should apply for more credit.
Mortgage lenders are not the only lending companies to use this metric. If you’re interested in applying for a credit card or an auto loan, lenders may use your DTI to determine if lending you money is worth the risk. If you have too much debt, you might not be approved.
How Much Does Debt-to-Income Ratio Affect a Credit Score?
Your income does not have an impact on your credit score. Therefore, your DTI does not affect your credit score.
However, 30% of your credit score is based on your credit utilization rate or the amount of available on your current line of credit. Generally, your utilization rate should be 30% or lower to avoid having a negative effect on your credit score. That means that in order to have a good credit score, you must have a small amount of debt and actively pay it off.
How to Lower Debt-to-Income Ratio
The only way to bring your rate down is to pay down your debts or to increase your income. Having an accurately calculated ratio will help you monitor your debts and give you a better understanding of how much debt you can afford to have.
Avoid employing short-term tricks to lower your ratio, such as getting a forbearance on your student loans or applying for too many store credit cards. These solutions are temporary and only delay repaying your current debts.
What is the Best Debt-to-Income ratio?
Long term, the answer is “as low as you can get it.”
However, hard numbers are better tools for comparison. Take a look at the following DTI ranges:
- 35% or less = Good
- 36-43% = Acceptable but Needs Work
- 44% and up = Bad
If you’re trying to get a home loan, 36% is the most recommended debt-to-income ratio. If you don’t have a significant down payment saved up, 31% is a better target.
Need Help to Lower Your Debt-to-Income Ratio?
Your DTI is an important tool in determining your financial standing. If you’re struggling to come up with ways to lower your ratio or are looking for financial guidance, our expert coaches can help you. Contact us today to learn more about how our Debt Management Plans can help you take control of your debt payments.