Debt-to-income ratio defined
Your debt-to-income ratio (DTI) is a comparison of your total monthly debt payments to your total monthly income. It’s an important metric that lenders use to determine whether or not you qualify for loans.
Why does my debt-to-income ratio matter?
Your DTI is an important factor in determining your creditworthiness. Lenders evaluate the risk associated with lending you money based on your DTI, as this metric provides a snapshot of how much you can comfortably afford to borrow.
What's a good debt-to-income ratio?
Typically, lenders look for applicants with a DTI below 36% (some will consider slightly higher percentages up to 43%). If your DTI is higher than 36%, it’s important to work on lowering your ratio before applying for a loan. This may involve paying down existing debt or taking other steps to improve your credit score, such as correcting errors on your credit report.
How debt-to-income ratio is calculated
You can calculate your debt-to-come ratio by taking the sum of all your recurring debts, such as your rent, mortgage, credit cards, student loans, and other financial obligations, and dividing it by your gross monthly income.
The resulting number is expressed as a percentage. For instance, if your total monthly debt equals $3,800 each month and your gross monthly income is $8,000, then your DTI would be 47.5%.
3,800 / 8,000 = 47.5
Debt-to-income (DTI) ratio example
Here’s a hypothetical example of how debt-to-income ratios work:
Total monthly debt obligations
If your monthly car loan payment is $300 and your student loan bill is $250, your total monthly debt is $550.
Gross monthly income
If your gross monthly income is $5,000, you will calculate your DTI ratio by dividing 550 by 5,000 to get 0.11.
Calculate to find your DTI percentage
Simply multiply .11 by 100, and you'll end up with 11%. This number represents the percentage of your monthly income that goes toward monthly debt payments.
If you want to skip the math, the Consumer Financial Protection Bureau (CFPB) also has a calculator you can try out.
What are front-end and back-end ratios?
Mortgage lenders consider two factors when calculating the DTI ratio: the front-end ratio and the back-end ratio. These two ratios play a crucial role in determining one's eligibility for a mortgage.
- Front-end ratio: Also known as the housing ratio, it indicates the percentage of your monthly gross income allocated to housing expenses. This includes your mortgage payment, property taxes, homeowners insurance, and association dues.
- Back-end ratio: The percentage of your income required to meet all monthly debt obligations, including your monthly mortgage payment, auto loans, credit card payments, child support, personal loans, and any other revolving debt that would appear on your credit report.
What's the difference between a debt-to-income ratio and a debt-to-limit ratio?
The debt-to-income ratio is often grouped with the debt-to-limit ratio, but it's important to understand their unique differences. To understand their significance and practical implications better, let's explore these metrics.
It's important to understand that lenders are interested in assessing whether you utilize your credit cards to their maximum extent. The debt-to-limit ratio, or the credit utilization ratio, represents the percentage of a borrower's total available credit currently being used.
The DTI ratio helps determine how much of your monthly income goes towards debt payments. Credit utilization assesses your debt balances in relation to your available credit from credit card companies.
Does DTI affect my credit score?
Credit bureaus do not consider your income when calculating your credit score. As a result, your debt-to-income (DTI) ratio has minimal impact on your actual score. However, individuals with a high DTI ratio may also have a high credit utilization ratio, constituting 30% of your credit score.
How can I lower my DTI?
The best way to lower your DTI is to pay down existing debt. Make sure to focus on debts with the highest interest rates first, as this will help save you money over time and lower your DTI.
If possible, make more than the minimum monthly payments and avoid taking out additional loans or credit cards until your DTI is back within a reasonable range.
Additionally, creating a spending plan and sticking to it can help you save money each month, which can then be used to reduce your overall debt burden.
Finally, it’s important to monitor your credit score as you work to improve your DTI. Regularly monitoring your credit report will help ensure that errors don’t go unnoticed and allow you to spot any suspicious activity that could be dragging down your score.
Final word
One of the most important steps you can take to get your finances in order is to monitor and keep track of your debt-to-income ratio. Understanding this metric is key to evaluating how much you can afford to borrow and ensuring that credit bureaus accurately reflect information about your financial situation.
Regardless of your debt-to-income ratio, it’s important to remember that help is available if you need it. Whether through personal finance advice from friends or family, consulting with a credit counselor or financial planner, or taking advantage of consumer protection organizations like the CFPB, plenty of resources are available to help you manage your debt and get back on track.
To speak with an unbiased CFP® Professional that will always act in your best interest, set up a call with Facet by clicking below.
