There are a lot of terms in the world of finance that you should know about. One of them is the Debt-to-Income ratio. Among all other ratios, this ratio is crucial to understand since it impacts your credit score and ability to take loans.
The definition of Debt-to-Income ratio
The debt-to-income (DTI) ratio allows you to compare your total debt payments to your income. The higher the DTI ratio is, the more debt you have compared to your income.
This ratio comes in handy for lenders. This is because it allows them to gauge your ability to repay debt. For instance, if you have a high DTI, the chances of you repaying debt may seem like a challenge.
To find out what your DTI ratio, all you need to do is divide your total monthly debt with your total monthly income. Multiply it by hundred to get a percentage value.
To find out how much your total monthly debt is, you must add up payments including credit card payments, mortgage or rent, loans (personal, auto or student loan) and child support or alimony payments.
Look at your credit report. If other debt payments are being reflected on it, add them as well to find your total monthly debt.
Then, divide this value by your monthly income. Make sure to divide by your income before tax and not after deductions. After dividing your debt with your total income, convert it into a percentage to find your DTI ratio.
Make sure you don’t include monthly utility, grocery or insurance payments as part of your debt. These don’t classify as debt. This is because when a lender is assessing your attractiveness as a borrower, he won’t be looking into these budgetary items.
What does DTI signify for your debt?
You might wonder, why is this ratio given so much importance? This is because Debt-to-income ratio reflects your ability to handle your debt. It also signifies whether you already have a lot of debt on you, and hence can’t afford any more debt payments.
You can decide what to do about your debt situation based on the DTI ratio. For instance, if the percentage is between 0% and 14.9%, you are good to go and can pay off your debt on your own. Debt avalanche and snowball methods might be perfect for you.
However, if you have a DTI ratio between 15% and 39%, you would need a debt management plan to sort out your debt situation. This is especially true if the majority of your debt is coming from a credit card.
Talk to a professional or bankruptcy attorney to know about your debt relief choices. Finally, if your DTI is more than 40%, it is time to consider bankruptcy and other debt relief options.
A good Debt to Income Ratio: What should you aim for
What lenders consider to be a good DTI ratio may differ from one lender to another. However, generally, it has been observed that everyone expects you to have a front-end ratio of at most 28% and a back-end ratio (after adding expenses) to be at most 36%.
Does this mean that if you have a higher ratio than the one mentioned, you won’t qualify for a loan? Well, the answer to this depends on other factors as well. Lenders take into account much more than your DTI ratio. They look into your savings, down payments and credit score as well. If all is well, you might end up qualifying for a loan despite a high DTI.
As per observations, 43% DTI is the highest you can go if you wish to qualify for a mortgage. Anything above it is a warning sign for lenders.
Are there any exceptions to this rule? You will be happy to know that there are a few anomalies. For instance, Fannie Mae and Freddie Mac backed conventional loans now accept a ratio of at most 50%.
Impact of DTI on Credit
While credit bureaus don’t consider your income when assigning you a credit score, borrowers that have a high DTI end up having a high credit utilization ratio. Since this ratio accounts for 30% of your credit score, inadvertently, DTI does impact credit.
What is the credit utilization ratio? It is the outstanding balance on your credit account compared to the maximum limit for credit. So, if you have a credit card limit of $4,000 and a balance of $2,000, the ratio would be 50%.
It is advised that the ratio should be below 30% if you wish to apply for a mortgage.
Improving Debt-to-Income Ratio
Here is how you can improve your DTI ratio:
- Pay off your credit card payments to reduce total debt incurred
- Don’t take more loans
- Opt for a debt consolidation loan which allows you to pay off debt at a quicker rate
- Try to increase your income by doing multiple jobs or demanding a raise.
- Assess whether you can live with some budgetary cuts through which money can go to debt repayments.
If you are applying for a mortgage, know that lenders will look at your DTI ratio since it reflects your ability to pay back the loan. They will also look at your credit score. Strive to improve both.
Do so by:
- Paying off your current debts to improve both DTI and credit utilization ratio.
- Be punctual and regular with your repayments to avoid negative payment history on your credit report.
- Don’t apply for new credit too often since it may lead to hard inquiries that might lower your credit score.
- Be wise with your credit usage and have a positive payment history.