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Picture this: You’ve decided to purchase your first home and think you have your financial ducks in a row. You’ve saved money to cover the down payment and closing costs, worked on improving your credit, and started gathering financial documents like your W-2 and pay stubs to get preapproved for a mortgage. Then, you hear about your debt-to-income ratio, a number you’ve never come across.
Not to worry. We’ll break down the DTI ratio and explain why creditors find it so important.
What is the debt-to-income ratio?
Some financial figures are complicated—but with this number, what you read is what you get. The debt-to-income ratio compares how much you spend to pay off your monthly debts with how much money you make each month.
This number is one of the factors that creditors use when determining whether or not to loan you money. The lower your ratio, the more expendable income you have after making your minimum payments.
How do you calculate your debt-to-income ratio?
Simple math is all it takes to calculate this percentage. First, look at your paycheck and find your gross income—the amount before taxes and deductions like insurance premiums and 401k contributions are taken out. If your income varies from month to month, you can instead use your average gross income for the last few months.
Next, add up your minimum monthly debt payments like your student loans, credit card debt, child support, and rent or mortgage payments. Then, divide your monthly debt total by your gross monthly income. To convert to a percentage, multiply that by 100. Let's see the formula in action, with a gross monthly income of $7,000.
Minimum loan payments:
- Credit card: $200
- Car loan: $400
- Student loan: $400
- Rent: $1,100
- Loan total: $2,100
Loan payments divided by gross monthly income: $2,100 / $7,000 = 0.3
Percentage conversion: 0.3 x 100 = 30%
In this example, your debt-to-income ratio is 30%.
It’s important to note that your debt-to-income ratio does not take into account other essentials like utilities, groceries, phone bills, or anything paid for in cash. For example, if you use a babysitter weekly, and pay him or her in cash, the expense will not be reflected in your debt-to-income ratio.
So, while the DTI ratio is a metric lenders use, it does not provide a complete breakdown of how your income compares to your expenses. When creating your personal budget, it’s important to include all of your expenses—and not just the ones used in the DTI ratio calculation.
What is a good debt-to-income ratio?
Generally, anything below 36% is considered a healthy number and will open more doors with creditors. It shows that after paying your debts, you have almost 70% of your gross monthly income to use toward other things like savings and medical bills.
If, for example, your debt-to-income ratio hovered near 70%, that would mean you have 30% left. In other words, you do not have much wiggle room for unexpected expenses and purchases. In the eyes of a creditor, the more expendable income you have, the easier it will be to make your monthly payments.
A debt-to-income ratio between 36% and 43% is OK, but not great. You’re steadily approaching spending almost half of your income on debt, which makes creditors wary.
While every creditor has different standards, if your DTI ratio falls in this category, your loan may be approved under less favorable terms. You may have a higher interest rate, for instance. Anything above 43% and creditors may think you're a risky borrower, or someone who will have trouble paying off a loan.
What types of lenders use the debt-to-income ratio?
You’ll most commonly hear about the debt-to-income ratio in the context of mortgage loans, but any creditor—think a personal or auto loan—can use this number to determine whether or not to lend you money. Because mortgages are more heavily regulated than other loans, your debt-to-income ratio will come under more scrutiny in this scenario.
How can you improve your debt-to-income ratio?
Since there are two numbers included in the formula, there are only two things you can change to decrease your debt-to-income ratio. You can either increase your income or decrease your loans, according to Michael Bovee, a co-founder of Consumer Recovery Network (CRN) who coaches clients through debt and credit problems.
Bovee says that if you’re able to make more money and don’t take on more loans, you can lower your DTI. If your income remains stable, but you rework your budget to pay off your car loan, for example, your DTI will also decrease. This is why when working with a mortgage lender, they may suggest paying off an account before officially submitting an application. If you hit the double whammy of increasing your income and decreasing your monthly loans, your DTI will decrease even more.
Bovee encourages his clients to make immediate changes after a life event occurs—like divorce, a job promotion, or an unexpected medical emergency. These examples would drastically change either your debt or income, and thus alter your DTI ratio.
“We are an optimistic lot as humans, and we need that optimism,” he says. “But when something happens with our cash flow, we start drawing down our savings and making decisions based on that optimism. The key, though, is to make adjustments immediately.”
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