Because your debt-to-income ratio can affect whether you qualify for a loan, you should know yours and how to lower it, if necessary, before asking to borrow funds from a financial institution.
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If you’re thinking about applying for a loan or another type of lending product, it’s important to understand the term debt-to-income (DTI) ratio. Your debt-to-income ratio compares your monthly debt payments — for things like housing, credit cards, car payments, personal loans and other financial obligations — to your total monthly pretax income.
The resulting percentage tells lenders how much of your income you spend on monthly debt obligations compared to how much income you earn each month. In turn, your DTI can impact whether you qualify for a credit card or a loan and can also affect your credit card limit or maximum loan amount if you’re approved. Before applying for a loan, you should understand what a DTI ratio is, how it affects your revolving and non-revolving credit, and how to calculate yours.
What is a debt-to-income ratio?
Your debt-to-income ratio tells lenders how much of your income you spend on monthly debt obligations compared to how much income you earn each month. This lets lenders know how risky you are to lend to.
In general, a low DTI demonstrates that you likely have extra funds to cover new loan payments and are the type of consumer who tends to make regular payments. Because of this, banks generally prefer lending funds to those with a low DTI. On the other hand, a high DTI indicates that you may take on more debt than you can manage with your income. In the bank’s eyes, you’ll likely have a hard time making regular payments. Therefore, if you have a high DTI, banks are less likely to extend a loan to you.
How to calculate your debt-to-income ratio
Calculating your DTI is relatively straightforward.
To start, add up all your monthly debt payments, including rent or mortgage, student loan payments, auto loan payments and credit card payments. Then, divide this sum by your total gross monthly income. Multiply the resulting figure by 100, and the resulting percentage is your debt-to-income ratio.
For example, let’s calculate DTI based on the following monthly gross income and expenses:
Monthly gross income
- Rent payment: $1,200
- Car loan payment: $600
- Credit cards: $400
- Other miscellaneous bills: $300
$1,200 + $600 + $400 $300 = Monthly debt payment total: $2,500
To find the monthly DTI, you would divide the total monthly debt payments by the total gross monthly income:
$2,500 / $6,000 = 0.416
That number is expressed as a percentage, so in this case, the monthly DTI would be 41.6 percent, or 42 percent if we’re rounding up.
What is a good debt-to-income ratio?
What exactly qualifies as a good DTI? Most lenders generally prefer your DTI ratio to be at or below 35 percent because this ratio signals that you likely have enough money after paying off your other debts to repay the new debt you’d like to take on, on time and every month.
DTI percent ranges
A good DTI is typically under 35 percent for most lenders, but what about the other DTI ratios? How do banks see them? Here’s a breakdown of the DTI ranges and what they typically mean to lenders:
- 35 percent and below: This DTI range is typically considered good by lenders, and generally means you have a good amount of money left over after your debts to spend, invest or save. Alternatively, you should have room in your income to take on new debt, with a high likelihood that you’ll be able to pay back the lender promptly.
- 36 percent to 42 percent: If you fall in this range, you still have workable debt, but you could be managing it better. If you ask for a particularly large loan or one offered by a stricter lender, the bank may ask you to work on lowering your DTI before you’re approved. With your debt in this range, you could likely lower it yourself rather than seek professional help.
- 43 percent to 50 percent: If your DTI is in this range, it suggests you have high debt, and your loan application may be declined. You may be managing your debt, but any sudden financial crisis, such as loss of employment or a medical emergency, may render it difficult to balance. In this range, you may consider more serious debt payment strategies, such as a debt consolidation loan or debt management plan.
- 51 percent and above: At 51 percent or more, your DTI is no longer considered sustainable. Most lenders won’t extend a loan to those with DTI ratios this high, but there are instances in which you can have a high DTI but not carry a balance from month to month. For example, this may occur if you purchase an expensive home that leaves you with little money in your budget each month, but you are still able to make your mortgage payment on time and in full.
Debt-to-income ratio vs. credit utilization ratio
Your DTI impacts your approval odds for a credit card or loan application, but it does not directly affect your credit score. Instead, your credit score is based, in part, on your debt-to-credit ratio, also known as your credit utilization ratio.
Your credit utilization is your amount of credit being used divided by your total credit limit. This ratio, which makes up 30 percent of your FICO score, accounts for revolving credit but not installment loans, such as car loans or home mortgages. Your DTI, on the other hand, is not reported to the three national credit bureaus and is not included on your credit report.
You should stay on top of both your DTI and your credit utilization, as they’re both important markers of how you handle debt. And while your DTI doesn’t directly affect your credit score, your income can still play a role in whether you’re approved for a new credit card or loan.
How to lower your debt-to-income ratio
Because your DTI is made up of debt and income, lowering it is straightforward — you either lower your monthly debt or increase your gross monthly income. Here are some actions you can take to reduce your DTI:
- Stick to a budget: Whether you create a budget manually or use an app, it’s good to assign your money a purpose so that you don’t accidentally overspend. Start by identifying unnecessary expenses that you can cut, such as impulse purchases or rarely used subscriptions. Once you’ve built your savings, you can use part of it to pay off your existing debt.
- Pay off part of your debt: While interest rates on credit cards are high right now, it may make sense to focus your efforts on paying off your credit card debt to reduce your DTI significantly instead of letting your card debt accrue high interest charges. You can slowly chip away at your debt by adopting the snowball or avalanche methods.
- Increase your income: You could take on additional part-time or freelance jobs, such as driving for Uber or teaching English remotely. You could also look for opportunities to advance in your career or ask for a raise or a bonus at your job.
The best strategy for lowering your DTI depends on your unique situation. In any case, improving your DTI can help ensure you’re in a good position to take on additional debt where you may need it.
Your DTI — your monthly debt payments in relation to your monthly gross income — is an important indicator of your ability to repay loans. While DTI does not impact credit scores, lenders generally prefer to extend loans to consumers with a DTI ratio of 35 percent or lower. If you think your DTI is too high to get approved for a loan, you should work to lower it by budgeting or repaying some of your debt to improve your chances of approval.