Your debt-to-income ratio (DTI) compares your total monthly payments for all of your regular debts to your total monthly income. Lenders use your DTI to help them decide whether you can afford to take on a new loan and whether you’ll be able to make the payments.
Knowing your DTI will help you evaluate your own financial stability and your ability to qualify for a new loan.
Your debt-to-income ratio (DTI) is the percentage of your monthly income that goes to pay recurring debts. Lenders use your debt-to-income ratio to assess your ability to manage new debt. A low DTI suggests that you can afford to take on more debt. A high DTI indicates that more debt could stress your ability to pay.
You may hear lenders refer to front-end and back-end DTI. Your front-end DTI is the percentage of your monthly income specifically devoted to housing costs. This is of particular interest to mortgage lenders.
Your back-end DTI includes all of your recurring debts and is used by all types of lenders. Unless a lender refers specifically to front-end DTI, you can assume that any reference to debt-to-income ratio refers to your back-end DTI.
To calculate your debt-to-income ratio, you will need to make a list of all of your recurring payments. These types of payments include:
Get a copy of your credit report and make sure you are listing everything on it. If you are paying debts that are not listed on your credit report, include them anyway.
Add the payments on your list together to arrive at your total monthly debt payment. Now combine all your sources of income to arrive at your average monthly income. Use your gross income before taxes and other deductions.
Divide your monthly debt by your total monthly income to get the DTI ratio. To express this as the typical percentage, multiply that number by 100.
For example, if your total monthly debt payments are $2000 and your total gross monthly income is $5000, 2000/5000 is 0.4. Your DTI is 40%.
The lower your debt-to-income ratio, the better. Different lenders use different standards to determine whether they are willing to lend to you, but all lenders prefer low DTIs to higher ones..
If your debt-to-income ratio is high, a lender may conclude that you represent a high risk and charge you a higher interest rate than a borrower with a lower DTI. If you are above a lender’s cutoff point, they may not lend to you at all.
There are some guideposts to help you determine how your DTI compares to others:
Many lenders will publish their DTI requirements. If they don’t, ask before applying, especially if your DTI is over 40%. Knowing the lender’s DTI cutoff will help you avoid applying for loans that you will not be able to get.
Knowing your DTI can also help you plan your own finances. If your DTI is over 50% you’re likely to have limited funds for daily needs and you may not be able to cope with unexpected expenses. You may wish to limit new debt and prioritize paying off your existing debts.
There are two ways to lower your DTI: increase your income or lower your debt.
You can increase your income by asking for a raise or taking on additional work on the side. You can also look for a higher-paying job, but if you’re planning to apply for a mortgage, remember that many lenders are also suspicious of rapid job changes.
You can also lower your DTI by paying off some debt. There are several approaches to reducing debt.
Any debt reduction strategy will be more effective if you avoid taking on new debt.
If you’re considering a large loan like a mortgage or a car loan, you can lower your DTI by making a concerted effort to pay off old debt and avoid new debt before applying for your new loan.
Your DTI does not directly affect your credit. As long as you are paying all of your debts on time, a high debt load relative to income will not damage your credit. Your income is not a factor in calculating your credit, so any ratio involving income will also not be a factor
The total amount you owe affects your credit utilization, which is a component of your credit score. Credit card debt has a greater impact on credit utilization than it does on DTI, but in general, owing more will increase your credit utilization. Try to keep your credit utilization below 30%, regardless of your DTI.
DTI is not the only factor that lenders use to evaluate your loan application. They will also review your credit score, credit report, employment status, and income, among other factors.
Your DTI still has a significant impact on your ability to borrow. Lenders will be reluctant to lend to borrowers with a high DTI. They may charge higher interest rates, and they may not lend at all.
You can also use your DTI to determine whether you want to apply for a new loan. A high DTI is a sign that you may not be able to take on new credit without the risk of default.
Knowing your DTI and tracking how it changes over time will help you determine whether you’re ready for a new loan and which loans you’d qualify for. It’s an important tool for monitoring and evaluating your finances.