Your debt-to-income (DTI) ratio is a financial metric that lenders use to assess your ability to manage monthly debt payments relative to your income.
Your total monthly debt payments include costs such as:
- Mortgage/rent payments
- Minimum credit card payments
- Auto loans
- Student loans
- Personal loan payments
- Other loan obligations
- Alimony or child support payments
Lenders view the DTI ratio as a gauge of your financial health and ability to take on and responsibly repay additional debt such as a new mortgage, car loan, or credit card. Having a low DTI ratio shows you have plenty of income left over after paying existing debts each month.
How to Calculate Your Debt-to-Income Ratio
You can calculate your DTI ratio by dividing your total recurring monthly debt by your gross monthly income. Follow these steps:
1. List out all your monthly debt payments.
2. Add up the total of those recurring debt payments.
3. Find your monthly gross (pre-tax) income by looking at recent pay stubs or tax documents.
4. Divide your total monthly debt payments by your gross monthly income.
5. Multiply that figure by 100 to get your DTI ratio as a percentage.
For example, if your total monthly debt payments are $2,500 and your gross monthly income is $6,000, your DTI ratio would be: ($2,500 / $6,000) x 100 = 41.67%
Why Your DTI Ratio Matters
Your debt-to-income ratio directly impacts your ability to get approved for loans and new credit lines at favorable interest rates. This is because:
- Lenders use your DTI ratio to predict if you can realistically afford the potential new monthly debt on top of your existing obligations.
- A lower DTI ratio demonstrates you have plenty of income remaining after debt payments to cover living expenses and additional loans.
- A higher DTI ratio signals you may be overextended, presenting a higher default risk for lenders.
Most mortgage lenders prefer a DTI ratio under 28% for just the mortgage payment itself, or 36% for your total DTI ratio including all recurring debts. However, minimum requirements can vary based on credit score, down payment, loan type, and other factors.
For example, a DTI ratio over 43% would likely lead to challenges in qualifying for a conventional mortgage at an affordable interest rate. But with compensating factors such as a higher credit score or down payment, some lenders may approve DTI ratios up to 50%. Similarly, lower DTI ratio requirements often apply to auto and personal loans.
In short, while a lower DTI ratio doesn’t guarantee loan approval, it can put you in a much stronger position compared to higher DTI ratios.
Front-End vs. Back-End Debt Ratios
When evaluating DTI ratios, lenders often differentiate between front-end and back-end ratios.
The front-end debt ratio only considers housing costs such as rent/mortgage, property taxes, homeowner’s insurance, etc. Most lenders prefer this number to be under 28%.
The back-end debt ratio (also called the total DTI) includes all recurring debts such as mortgages, credit cards, loans, alimony, etc.
Here are some key reasons lenders scrutinize the front-end ratio specifically:
- Housing is typically the largest recurring expense for most households.
- Underwriting guidelines put emphasis on ensuring sufficient residual income after housing costs.
- Mortgage payments are given higher priority over other debts such as credit cards if money gets tight.
While exceeding the 28% front-end guideline isn’t an automatic denial, it can raise caution flags for lenders and may require stronger compensating factors such as higher income, credit score, assets, etc.
Strategies to Help Lower Your Debt-to-Income Ratio
If your DTI ratio exceeds recommended thresholds, focus on lowering it before applying for new credit or loans. Effective tactics include:
- Pay down existing debts such as credit cards and loans faster by allocating more monthly income.
- Explore debt consolidation loans or balance transfer cards to lower interest costs and monthly payments. Before committing to a balance transfer, it is important to consider whether balance transfers could hurt your credit.
- Refinance mortgage, student loans, or auto loans to a lower interest rate and payment.
- Ask for income-based repayment plans on federal student loans to help reduce required monthly payments.
- Increase your income through career advancement, a side gig, rental income, etc.
- Consider downsizing housing costs by moving or renting out part of your home.
FAQs
What is considered a good debt-to-income ratio?
Most lenders prefer a DTI ratio under 36% for overall debts, with the housing payment itself below 28%. However, those are just guidelines, not hard limits. Many still qualify with higher ratios depending on credit score, assets, down payment, and income stability.
How does my DTI ratio affect getting approved for loans?
Lenders use your DTI ratio as a key approval factor because it predicts your ability to afford the potential new loan payment on top of existing debts. A high DTI above 43% for a mortgage or 50% overall makes approval much more difficult without compensating factors.
What debts should I include in my DTI ratio calculation?
You should include all recurring monthly obligations in your DTI ratio. This means mortgage/rent, auto loans, student loans, minimum credit card payments, personal loans, alimony, child support, etc.
Can my DTI ratio change over time?
Absolutely. Your DTI ratio can fluctuate as your income and debt levels change. It’s wise to regularly recalculate your DTI ratio, especially before applying for new credit, to help ensure it remains at an acceptable level for lenders.
Does my DTI ratio impact my actual credit score?
Your DTI ratio is not used in calculating your credit score. However, lenders do look at your DTI ratio alongside your credit score when making approval decisions, as the two metrics combined help predict your future repayment risk.
Bottom Line
Your debt-to-income ratio is one of the most influential factors mortgage lenders, banks, and credit card companies review. A high DTI ratio can potentially disqualify you from loans or force you to pay higher interest rates due to the higher default risk.
Credit & Debt offers financial coaching and customized debt management plans to help people like you lower their DTI ratio. Get in touch with a financial coach today!
