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 calculate 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 gross monthly income. 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 36% or below. 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 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.
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.
So how do you improve your Debt-to-Income Ratio?
Since the only factors determining your DIT is income and debt, this means that the only way to lower your debt-to-income-ratio is to pay down your debts or 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. This is all easier said than done, though. Below are some creative strategies you can use to help improve your debt-to-income-ratio.
- Pay off your loans ahead of schedule
While loans typically have a repayment plan, you do not have to stick to this. If your budget has room for extra payments, you could pay off your debt ahead of schedule. One way to tackle this would be to adopt the snowball method, which involves paying your smallest debt first and then working your way up to the biggest. Conversely, you could use the avalanche method which involves paying off the debt with the highest interest rate first while making minimum payments towards your other debts.
- Refinance your debt with a new lender
If you are unable to pay off your loans or debt ahead of schedule, restructuring your debt may work for you. One option is to refinance if you qualify for a lower interest rate or can change your repayment terms. Pursuing refinancing may also allow you to lower your monthly payments which will also have a positive impact on your debt-to-income-ratio.
- Use a balance transfer to lower interest rates
Shop around for zero interest credit cards that offer 0% APR for a promotional period. Transferring your debt to a credit card like this can help you tackle your debt quicker while you don’t have to worry about interest fees during the promotional period. Be careful with this method, though. If you don’t pay off your debt before the promotional period is up, your interest rate could skyrocket and you may be left paying more than you were before. This could have an adverse affect on your DTI.
- Target debt with the highest bill-to-balance ratio
This strategy revolves around targeting the debt that will reduce your debt-to-income ratio the most using the least amount of cash. If you owe $200 on Card A that has a monthly payment of $40, and you owe $100 on Card B that has a monthly payment of $50, you would want to start by paying Card B because the monthly payment is 50% of your balance whereas Card A’s payment represents 20%. Using this method will have a higher impact on your DTI.
- Negotiate a higher salary/find a side gig
As stated before, increasing income is one of the two ways to improve your DTI. If you are unable to do any of the above–or even if you are– increasing the amount of money you bring in will lower your debt-to-income ratio. Asking your employer for a raise can be a great turn of events you might not have expected positive results from. Finding a side gig can allow you to allocate all extra earnings to debt and help get it paid quicker.
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.
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 Credit.org’s Debt Management Plans can help you take control of your debt payments.