Debt-to-income (DTI) measures how much money you owe in debt compared to your income. It can help you keep track of your financial health and improve your spending habits, such as saving more money or paying down debt faster.
Financial institutions also use the DTI ratio to determine the amount of risk they take when extending credit. Specifically, they use it to determine your ability to repay a loan or how much funds you can borrow.
If you’re planning to take out a loan, read on and learn more about the DTI ratio.
How to Calculate DTI Ratio?
The debt-to-income ratio can be calculated by dividing your monthly gross income by your total recurring monthly debt payments. Let’s say you have a monthly debt payment of $2,400 and a total monthly income of $3,000. Your DTI ratio would be calculated this way:
$2,400 / $3,000 = 0.71 or 71%.
Why Does It Matter?
Your DTI ratio can affect whether or not lenders approve your traditional or online loan and credit card applications. It generally tells financial institutions whether you can responsibly manage debt.
If your DTI ratio is too high, issuers or lenders will more likely reject your application. A high DTI ratio may indicate that you’re spending too much of your paycheck on debt repayment and may not be able to pay off the debt you currently have in the future. Banks usually see these as red flags in their underwriting process.
In contrast, having a low DTI is a sign of financial responsibility. It shows lenders that you can make payments on your loans without taking on additional debt or living paycheck to paycheck. As a result, lenders will likely approve your application faster and offer you more competitive rates and terms.
What’s a Good DTI Ratio?
A good DTI ratio is typically less than 36%. However, it depends on several factors like how much money you make and how much debt you have (and some lenders may be more lenient). If possible, aim for a DTI below 30%.
If your DTI ratio exceeds 36%, it doesn’t necessarily mean you won’t be approved. Again, depending on the lenders, other factors can come into play. However, most of the time, having an unusually high debt load can make it more difficult to qualify for certain loans.
Quick Tips to Improve High DTI Ratio
If your DTI ratio is too high, you may have to wait until your debt is paid off before applying for a loan. If this is the case, consider getting a co-signer or trying to get a smaller loan. It will help your DTI ratio decrease and make it easier for you to qualify.
Alternatively, pay down high-interest debt first. For example, reduce the amount of money you’re paying on credit cards and other loans with high-interest rates. You’ll see a bigger boost in your DTI by paying off this type of debt than if you were to pay down a low-interest loan or mortgage.
Another way is to reduce monthly expenses. Look at how much money goes out each month for groceries, rent or mortgage, utilities (gas and electric), cell phone bills, and entertainment costs like cable TV subscriptions. Always prioritize your needs over your wants—this goes without saying.
For example, do you need that club membership? Can you cancel Netflix? How about switching from Amazon Prime delivery (which comes with free video streaming) to just buying things when they’re needed? These small changes can make a big difference over time. Give your wallet some breathing room now so that it doesn’t get squeezed later when it comes time for another loan payment.
Does DTI Ratio Affect Credit Rating?
Your DTI ratio doesn’t affect your credit score. Credit reporting agencies or bureaus are only interested in your debt history, not income. That’s why they don’t collect consumers’ income data, so DTI ratios aren’t reflected on credit reports.
Nevertheless, maintain a healthy DTI ratio. As stated, when you apply for a loan or credit card, financial institutions will likely request your income and take your DTI ratio into account. In other words, while it doesn’t directly impact credit standing, the DTI ratio is as important as your credit score during an application review process and to your overall financial health.
Lenders prefer borrowers with lower DTI ratios because they’re less risky. However, if your income is high enough that your risk tolerance increases, then lenders may still approve the loan despite its higher exposure to risk.