Your debt-to-income ratio compares your total monthly debt payments to total monthly gross income. Unlike credit utilization, it’s not a factor in your credit score. But it still matters to credit card issuers, particularly if your debt-to-income ratio is too high.
But make no mistake, it is still important to the credit card issuers. And it ought to be important for you, too!
Lenders use it to protect their loans against losses. But you use it to make sure you will have the money you need tomorrow. When you borrow money today, you are taking money from the future – money that you have yet to earn – and you are spending it today.
What happens if you empty your future fund today? You risk an empty future. Let’s examine what we are talking about, how it is different from credit utilization and ways to reduce to protect your future.
What is debt-to-income ratio?
First, let’s define debt-to-income ratio, commonly abbreviated DTI. Simply put, DTI compares total monthly debt payments to total monthly gross income.
Why gross? It took me a long time to realize that some people use payroll deductions to fund savings, retirement and other goals. So, the money’s not really gone, never to be seen again. It’s just in another form. That’s why we are talking about your gross income, not your net (how much you actually bring home each paycheck).
Also, the debt payments we are talking about include all of your debt, not just credit card debt. Mortgages, car loans and any other loans must be included. The comparison is done by dividing the debt payment by the gross. For instance, total monthly debts of $2,000 divided by a total monthly gross of $6,000 equals 33% DTI.
How does debt-to-income ratio differ from credit utilization?
As you know from my previous columns on what makes up a credit score, you will not see DTI as one of the components. Income information is not included in your credit report or score.
What is somewhat related, but not the same, is credit utilization. This is the percentage of credit used in relation to the total amount of credit offered. The formula for this is similar to DTI, in that it is the amount of credit used divided by the amount of the total credit line. For instance, if you spend $500 of a total credit line of $2,000 you end up with a 25% utilization. This factor makes up 30% of your FICO credit score and is second only to payment history in importance.
See related: Do you need current income to get a credit card?
How does debt-to-income ratio affect a credit card application?
So, does DTI matter when it comes to applying for and getting a credit card? It certainly can if your DTI is too high. Even though the factors that make up the DTI are not all necessarily asked in a credit application, your payment history and utilization will come up.
If you have a history of making only minimum payments on your credit card balances, your DTI is likely to be high, and your utilization will certainly be. But the real question I’d like you to consider is, how does your DTI fit in with the life you want, not just today, but tomorrow?
In broad terms when it comes to lending, those with a DTI of 35% or less are considered “favorable” and should qualify for most terms. Those with DTI’s in the 36% to 49% are “acceptable” but may need to make some improvements to qualify. At 50% you will find your choices very limited if you can get financing at all.
How to reduce your debt-to-income ratio
If you find yourself in those higher ranges, now is the time to make some changes. While it’s difficult to make drastic changes to a mortgage payment or to pay off a car loan sooner, credit cards offer a way to reduce both your DTI and your utilization numbers.
There are a couple of ways to do this:
- Stop adding to your balances through additional purchases, if minimum payments are all you can manage right now. Put those cards on ice, but don’t close them because that will bring your available credit down and your utilization up.
- Make higher payments on your cards. These payments must cover your current purchases if you are continuing to use the cards, as well as an amount to apply toward past purchases and interest.
To increase your income, you might consider selling some stuff online or at a yard sale or taking on a few hours of part-time employment (though both of these measures could be difficult amid coronavirus lockdowns and dwindling job opportunities). A little extra cash can make a big difference.
CreditCards.com’s handy calculators can help you figure out where you stand on your cards and what to do next. There is even a calculator to help you see if a balance transfer credit card is an option for you. If you can move your balance to a 0% APR or low-interest credit card, more of your money can go toward your debt. That’s a win-win in my book.
Remember to keep track of your score!