What is Your Debt-to-Income Ratio and Why is it Important?
If you’ve spent some time scrolling through popular financial blogs, you may have noticed the financial world uses a lot of jargon.
Luckily, you don’t have to spend years tapping through Duolingo to learn this language. This guide’s here to help you become more fluent in terms relating directly to your finances, even if you’re a total beginner.
One such term is debt-to-loan ratio, or DTI. Although you may not hear it as often as words like compound interest or amortization, DTI plays an important role in your finances and in your chances of getting a personal loan.
In order to get a better understanding of what that role is, let’s explore DTI inside out. Keep reading to learn how to calculate your DTI, why this number is so important, and how you can lower it.
What is a Debt-to-Income Ratio?
Have you ever wondered how much of your monthly paycheck you use to pay off your debts? If yes, then you’re halfway to figuring out your debt-to-income ratio.
DTI is an official calculation showing how much debt you owe in a month compared to your monthly gross income. Typically, it’s shown as a percentage. This percentage could be an excellent gauge of your finances, and it makes it easier to visualize your debt load.
While it’s a good exercise for anyone who wants to understand their finances better, it’s sometimes used by lenders. DTI may be an important metric used during the lending process, as some may look at your DTI when reviewing your application.
Every lender has different policies, including online direct lenders. Check out our quick guide to see what makes an online direct lender different from other lenders.
Lenders who check DTI use it to calculate your borrowing risk. Your DTI may give them insight into your finances and help them determine if the loan you’ve applied for is an affordable addition to your current debt load.
If your DTI is high, it suggests that you may not have enough cash on hand to pay back an additional loan. If it’s low, it indicates that you may be able to handle the payments associated with a new loan without difficulty or financial burden.
How to Calculate Your Total Debt Ratio
Finding out your DTI is easy. All you have to do is add up all your monthly debt payments and divide the sum by your gross monthly income.
What are monthly debt payments?
A monthly debt payment is any money owed to a lender, company, or person for any debts or amounts owed. It may include payments you make against credit cards, mortgages, lines of credit, installment loans, auto loans, and more. It may also include alimony and child support payments.
What is your gross monthly income?
It refers to the money you earn before deductions like taxes or Social Security Insurance are taken out. It may include basic wages, tips, commission, overtime pay, and more.
Now that you know what shapes monthly debt payments and gross monthly income, let’s see the DTI calculation in action.
An example of how to calculate your total debt ratio
Suppose your gross monthly income is $4,200.
Your calculation would look like this:
$1,925 ÷ $4,200 = 0.46
Multiply this result by 100 to create a percentage. Using this example, your DTI is 46 percent.
You can use a DTI calculator to help
If you’re still unsure about what does and doesn’t count as a monthly debt payment, check out this interactive DTI calculator for help. It walks you through some common debt payments and answers some questions about debt-to-income ratio.
Better yet, it crunches the numbers for you, so you’ll know your DTI without doing any more math than you have to.
What is a Good DTI?
As a general rule, the lower your DTI is, the better chance you have of being approved for a loan.
A lender wants to see a low ratio because it suggests you have fewer existing debts tying up your cash. It may make you more desirable as a borrower, as you may have the expendable cash to cover your loan repayments more comfortably.
It may also suggest that you’re less vulnerable to lifestyle changes. Should something happen to lower your income or increase your expenses, a low DTI may mean your finances have a bigger cushion. A lender may infer that you would still be able to pay your responsibilities even after these lifestyle changes.
So, what DTI should you be aiming for? In general, the industry has embraced something called the 28/36 Rule.
What is the 28/36 Rule?
The 28/36 Rule represents what’s generally an acceptable DTI. Some lenders may refer to the 28/36 Rule when deciding if a loan or mortgage is affordable for a potential borrower.
This guideline breaks down your DTI into two main categories:
- Your housing expenses
- Your total debt ratio
The 28 and 36 come to play as percentage caps representing the sweet spot for each of these categories.
1. Your housing expenses
The 28 in this rule specifies you shouldn’t spend more than 28 percent of your gross monthly income on housing expenses. This is sometimes called your front-end ratio debt.
It’s important to note housing expenses covers more than just mortgage payments or rent. They may also include:
- Insurance premiums
- Homeowner’s association fees
- Condo fees
- Property taxes
- Utility bills
Basically, housing expenses include any expected payments that go towards the maintenance of your home
2. Your total debt ratio
Also known as your back-end ratio debt, your total debt ratio is your DTI. It represents all your debts combined. According to this rule, your DTI shouldn’t be more than 36 percent of your gross monthly income.
What’s the Maximum DTI Lenders Will Accept?
But what if you surpass the 28/36 Rule? Can you still get approved for financing?
It may be possible!
According to the Consumer Financial Protection Bureau (CFPB) 43 percent is generally the highest DTI you can have and may still get a Qualified Mortgage loan.
What is a Qualified Mortgage loan?
A Qualified Mortgage loan is a more secure financing option for real estate. It hinges on the lender making what the government considers a good effort check into a borrower’s finances.
This means a lender should assess your DTI, credit, and other financial information to make sure the mortgage is affordable before you take it out.
Of course, there are some exceptions to the rule, but most Qualified Mortgage loan lenders may want to see that your DTI is below 43 percent.
You may still find another category of mortgage that allows higher DTIs, but you may want to consider these alternatives carefully. Typically, a Qualified Mortgage loan comes with better consumer protections.
How to Improve Your DTI
Improving your DTI revolves around two general rules. To see results, you’ll have to:
- Increase your income
- Decrease your debt
Depending on your finances, you may successfully lower your percentage by focusing on one or the other. Or, you may be able to tackle both options at once.
Increasing your income and decreasing your debt are no small feats! They’re some of the most common and most challenging goals people attempt every year.
To improve your chances of doing either, you may want to check out the following steps to reduce your total debt amount:
1. Cut expenses
Be honest with yourself and really look at how you’re spending money. Do you have bad spending habits that tie up your cash in unnecessary ways?
Most people have areas in their budget where they can slash costs and increase saving. If you can manage to find expenses you can live without, you may apply this extra cash towards your debt payments.
Any extra payment may reduce how much you spend in interest, and it may help you pay off your debt faster.
2. Cause a debt avalanche
For large debts, a popular repayment plan is the debt avalanche. Also known as debt stacking, this strategy focuses on paying off the loan with the highest interest first.
If following this method, you’ll make all the minimum payments on every debt except for the one with the highest interest rate. This loan will get any extra cash you have to put towards debt.
Once you pay this off, your next target is the loan with the second highest interest. The plan is to pour any of the cash that used to be tied up with the first debt into the second.
This method helps limit how much you pay in interest.
3. Throw a debt snowball
The above tip is a long-term debt repayment strategy that works if you can commit. But it may be a challenge to stick with if you like seeing immediate results.
The debt snowball method may provide the motivation you need. This strategy focuses your debt repayment on the smallest loan first, promising faster results.
Ultimately, you may pay more interest by choosing the snowball method over the avalanche. However, studies show a quick win may give you the morale boost you need to tackle the next largest loan.
Finding the right payment plan for your needs is one of the top tips on handling financial issues responsibly.
4. Use personal loans in an emergency
If you already have a high DTI, you don’t want to add to it by taking out additional personal loans.
Put large, unnecessary purchases on the backburner for now, especially if you’d need to take out credit to make them.
This strategy delivers a one-two punch to your finances. It means you won’t be adding to your total debt ratio by taking out credit. It also means you’ll have the opportunity to consider your spending carefully.
Do you really need that new gadget or pair of shoes? If the answer is still yes, think about how you would pay for them.
If you’d have to take out an installment loan or cash advance online, it’s not a good idea. These online loans are designed as short-term relief when you can’t take on an unexpected yet essential expense, such as an emergency medical bill.
Take some time to learn more about our online installment loans and why they’re better as an emergency backup — like when you face an unexpected bill during a tight month.
As for those must-have sneakers, tweak your budget to help you save up for such items on your own.
5. Earn more money
Increasing how much you bring home each month will affect your DTI ratio, effectively lowering your percentage even if your debt payments remain the same.
Consider sprucing up your resume and searching job boards to find a better paying position. You may be able to leverage your experience into getting a higher salary or hourly wage.
But there may not be any need for leaving your current position for a new one. If it’s available, take on overtime to boost your paycheck. If it isn’t, schedule a meeting with your boss and ask for a raise.
If these options aren’t possible, there’s still hope . If you have extra time, you may be able to get a part-time job or start a side hustle by monetizing a hobby. You can also check out these apps to help you boost your income.
Your DTI Matters
Learning how to improve your DTI is an important step towards reaching greater financial freedom.
Of course, the biggest and the most immediate perk to lowering your total debt ratio is that you may get to keep more cash in your pocket.
With less of your income tied up in paying down debt, you may be free to use your money as you like — whether it’s with a celebratory treat or with regular deposits in your savings.
But don’t let all this extra cash overshadow the other benefits to learning how to improve your DTI.
It may help you make improvements to your credit score. Although your DTI won’t directly impact your credit rating, the type of credit you have and the balances you carry will.
If you keep credit card balances from month to month, you may raise another important financial ratio — your credit utilization ratio. Accounting for a portion of the “amounts owed” section of your credit score – which is 30 percent of your overall score – a high credit utilization ratio may lower your credit score. By lowering your total debt ratio, you may reduce how often you carry a balance and therefore reduce your credit utilization.
With a lower DTI and a potentially higher credit score, you may have greater financial options. Until then, learn more today about your online loan options.
If you’re ready to take advantage of what a lower DTI can do for you, take some time thinking about how you may reduce this ratio. Good luck!