Your debt and your income are arguably the two most important elements of your financial health. Looked at together, they make your debt-to-income ratio.
You want one to stay low (debt) and one to grow steadily over time (income), but if the roles get reversed, things can get ugly, fast. If the former (debt) grows and the latter (income) stays the same, it’s not good either.
What is the Debt-to-Income Ratio?
Your debt-to-income (DTI) ratio divides your entire monthly debt payments by your gross monthly income. The result is a percentage that gives lenders an insight into your financial status and creditworthiness. The more debt you have, the higher your DTI will be.
Providers of loans, mortgages, credit cards, and even rental homes all use your DTI and credit history to evaluate your eligibility: whether they should do business with you, and on what terms. Some lenders generously accept people with higher DTIs than other lenders—but with a catch: higher interest rates or higher down payments.
The Consumer Financial Protection Bureau lists the benchmark for Qualified Mortgages at 43% DTI. Under that number, you’re more likely to get a stable and lower interest rate.
A DTI of 20% or less is ideal. It tells lenders you make plenty of money but don’t owe much. A DTI above 40%, on the other hand, screams, “I’m overloaded with debt! Help!” As a result, lenders become hesitant with DTI ratios above 40%.
Calculating Your DTI
It’s important to understand your debt-to-income ratio so that you can apply for loans and credit cards confidently and strategically.
First, add up all of your regular monthly bills and obligations. This includes your mortgage payment, car payment, credit card bills, student loans, and any other money you owe to a third party. Now add up your gross monthly income before taxes and other deductions are taken out of it.
Let’s say your monthly debt payments equal $2,000, and you have a $6,000 gross income every month. This means your debt-to-income ratio is $2,000 / $6,000, which equals .33 or 33%.
What happens if your debt is more substantial? Let’s say your total monthly debt payments equal $4,000, but your income is still $6,000 gross. That doubles your debt without any income increase, leading to a 66% DTI. Ouch.
Why Does DTI Matter?
Lenders look at two main criteria when considering your odds of approval: credit score and DTI. Your DTI may automatically disqualify you from a mortgage, car loan, or other important financial milestones if it’s too high.
This quick breakdown shows where you stand in the eyes of lenders based solely on your DTI:
- DTI of 40% or more: You may be able to gain mortgage approval if your DTI hovers under 43%, but you’ll receive denial letters from most lenders until you pay off a portion of your debt. If you’re in this class, consider researching debt relief options.
- DTI of 15% to 39%: You’re close! Try paying down at least one debt faster than required in order to decrease your DTI and improve your appeal to lenders. Ensure you don’t take on any new obligations until your current debt is cleared and/or your income increases significantly.
- DTI of less than 15%: You’ve made excellent financial choices, and they’ve paid off! You have a world of financial opportunities open to you.
In other words, may not be the right time to start house-hunting if your DTI ratio sits at 65%.
At the end of the day, knowing and understanding your DTI will help you plan your budget and prepare for major financial decisions in the future. Take strategic action now, so you can make the moves you want in the future.
Don’t wait to get out of debt! Read this: A Complete, Step-By-Step Guide to Get Out of Debt.
