Debt-to-Income Ratio Explained

Debt-to-income ratio is one of the essential calculations used in personal finance. This calculation helps lenders determine how much debt you can afford, and it is also a factor in determining your credit score. In this article, we will explain what DTI is and how to calculate it. We will also discuss why this calculation is so important and what a good DTI is. Stay tuned for more information!

What Is Debt-to-Income Ratio, and How Does It Work?

DTI is a key measure lenders use to determine whether someone is a good candidate for a loan. This ratio compares the amount of money a person owes (including monthly payments on mortgages and other debts) to their monthly income.

Generally speaking, the lower a person's DTI, the better the odds of being approved for a loan. However, different types of lenders may have different levels of risk tolerance. For example, mortgage lenders often have higher DTI requirements than those that offer student loans, home equity loans, or credit cards.

Ultimately, configuring your finances to achieve a low DTI can be an essential part of securing timely approval for any type of loan.

There are two types of debt included in the debt-to-income ratio: secured and unsecured. Secured debt includes debts that are backed by collateral, such as a mortgage or car loan. Unsecured debt includes credit card balances and other loans that aren’t backed by collateral.

To calculate your debt-to-income ratio, you will need to gather some financial information. Specifically, you’ll need to know your gross monthly income and total monthly payments on all debts. Once you have this information, you can use a DTI calculator or check the steps below.

How To Calculate Debt-to-Income Ratio

DTI is a financial metric that compares the borrower’s monthly debt payments to their monthly income. The higher the ratio, the more of a borrower's income is dedicated to paying down debts, and the less money they’ll have available for other expenses. A high DTI can make it difficult to qualify for a loan or line of credit and may lead to higher interest rates.

To calculate your DTI, divide your total monthly debt payments by your gross monthly income. Here’s how this debt-to-income ratio formula works. For example, if you have $500 in monthly debts and a gross monthly income of $2,000, your DTI is 25%.

While there is no hard rule about what qualifies as a "good" or "bad" DTI, lenders typically prefer to see ratios below 36%. Ratios above 43% are generally considered red flags.

If your DTI is on the higher side, consider taking steps to pay off your debt or increase your income. By doing so, you can improve your chances of getting approved for a loan with favorable terms.

Why Is DTI Important?

Now that you know what is included in the debt-to-income ratio and how it works let’s look at why lenders place so much importance on it. DTI is one of the key factors that lenders consider when making decisions about loan approval. That's because this calculation provides insight into a borrower's ability to repay their debts.

A high DTI may indicate a borrower is overextended and may have difficulty making their monthly loan payments. As a result, lenders may be hesitant to approve a loan.

On the other hand, borrowers with a low DTI are generally considered good candidates for loans. This is because they are less likely to default on their loan payments.

It's important to remember that the DTI is just one of many factors lenders consider when making lending decisions. Other factors include credit history, employment history, and income. 

What Is a Good Debt-to-Income Ratio?

Your DTI is one of the most important factors lenders look at when you apply for a loan. This ratio is a comparison of your total monthly debt payments to your monthly income.

A high DTI could indicate that you're struggling to repay your debts, which could make you a riskier borrower. Lenders often feel that a DTI of 36% or less is ideal. However, some may consider ratios as high as 48%, depending on your credit history and other factors.

If your DTI is too high, you may have trouble qualifying for a loan or may be offered less favorable terms.

Reducing your debt-to-income ratio can also help you qualify for a lower interest rate, which will save you money while repaying the loan. Improving your DTI is just one factor that can help you get better loan terms. You’ll also want to focus on other measures of creditworthiness, such as your credit score.

How To Improve Your DTI

There are a few things you can do to improve your DTI. Here are some of the most common strategies:

Pay Your Outstanding Debts

One of the most effective ways to improve your debt-to-income ratio is to pay off your outstanding debts. This includes both revolving debt, such as credit cards, and installment debt, like student loans or car loans. 

By paying off some of your debts, you can lower the amount of money you need to spend each month on debt payments. This, in turn, will increase your monthly income and lower your DTI. 

If you're unsure where to start, consider making a list of all your debts ranked from the highest to the lowest interest rate. Then, focus on paying off the debt with the highest interest rate first. 

You may also want to consider making more than the minimum monthly payment on your debts. Doing so can help you pay off your debt faster and improve your DTI. 

Increase Your Gross Monthly Income

Another option you can use if you wish to come to an ideal debt-to-income ratio is to increase your income. This can be done by working overtime, getting a promotion, or finding a higher-paying job. 

If you're self-employed, you may be able to increase your income by bringing on new clients or increasing your rates. 

Even a slight increase in income can make a big difference in your debt-to-income ratio, especially if it’s currently hovering around 36%.

Decrease Your Monthly Debt Obligations

If you can't increase your income, another option is to focus on decreasing your monthly debt obligations. 

You may be able to do this by refinancing your debt at a lower interest rate or consolidating multiple debts into one loan with a lower monthly payment. 

You could also consider deferring or forbearing certain types of debt, such as student loans. This could also help you lower monthly payments and improve your debt-to-income ratio. 

Debt-to-Income Ratio vs. Credit Score

Lenders use both DTI and credit score to assess an individual's ability to repay loans. A high DTI and low credit score may indicate that an individual is a high-risk borrower, while a low DTI and high credit score would show the opposite.

Individuals with a high DTI but strong credit history may still be approved for loans, but they may be required to pay higher interest rates. A similar situation could happen to individuals with a low DTI but weak credit history.

Your debt-to-income ratio does not directly affect your credit score. However, if you have a high DTI, it may be difficult to qualify for new loans or affordable personal lines of credit. This can negatively affect your credit score down the line, especially if you end up with a highly unfavorable loan that you’ll have trouble paying off.

Final Thoughts

Now that you know how to figure out your debt-to-income ratio, try to keep it in good standing as it is one of the key factors in your financial life. A high DTI can make your life difficult and get you into a spiral of ever-growing debt.

Still, there are several ways to lower your DTI, including paying off debts, increasing your income, and decreasing your monthly debt obligations. Just keep in mind that it may take some time to see the results of your efforts.