What is Debt-to-Income Ratio and Why Does it Matter?

If you’re looking to take out a loan in the near future, one number to pay attention to is your Debt-to-Income Ratio (or DTI ratio for short). This number tells lenders how much additional debt you can safely take on, based on your income and how much other debt you currently have.

What’s Your Debt-to-Income Ratio?

To calculate your DTI ratio, divide your monthly debt payments (things like your mortgage, car loan, student loan and credit card minimum monthly payments) by your monthly gross income (the money you make before taxes are taken out). There are also free online DTI ratio calculators available.

For example, let’s say you have a monthly gross income of $5,000. You have a $1,200 mortgage payment, a $200 car payment, a $100 student loan payment, and no credit card debt. Your monthly debt payments add up to $1,500, and your DTI ratio is 30%.

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Why is a Debt-to-Income Ratio Important?

While your DTI ratio isn’t one of the factors that determines your credit score, it does affect your ability to get a loan. Lenders look at your DTI ratio when determining your likelihood of being able to repay a loan, and they also use that number as they decide what interest rate to charge you.1

Basically, a higher DTI ratio = a riskier person to lend money to = a higher interest rate. That higher interest rate can cost you thousands of dollars over the life of a loan.

Two Numbers to Remember

What is a “good” DTI ratio? In other words, what is the highest DTI ratio you can have before you experience any consequences? Remember these two numbers: 36% and 43%.

In general, a DTI ratio of 36% is considered high and could potentially lead to higher interest rates.1 To figure out your maximum, simply multiply your monthly gross income by 0.36.

A 43% DTI ratio is the highest ratio you can have to still be eligible for a Qualified Mortgage.2 The “qualified mortgage” rule was instated in the wake of the 2008 financial crisis to prevent lenders from granting the kinds of risky loans that helped bring about the crisis.3

Get Out of Debt to Improve Your Debt-to-Income Ratio

Because your DTI ratio is based on your debt obligations divided by your gross income, the way to lower it is to lower your debt, increase your income or both. Your income includes bonuses and money earned through side jobs, so work hard at your job to earn raises and bonuses, and consider taking on freelance or side work to further boost your income.

Aim to get out of debt by paying it down aggressively, especially high-interest credit card debt. You can lower your interest payments by transferring your debt to a low-interest credit card, or a card that offers a no-interest introductory rate. This will save you money as you work toward being credit card debt-free.

Just watch for “balance transfer fees” when you shift to a card that offers a no-interest introductory rate. In addition, be sure you can pay off the card before the rate expires, otherwise, you could get caught owing accrued interest.

Resources:

1: http://www.creditkarma.com/article/debt-to-income-ratio

2: http://www.consumerfinance.gov/askcfpb/1791/what-debt-income-ratio-why-43-debt-income-ratio-important.html

3: http://files.consumerfinance.gov/f/201401_cfpb_mortgages_consumer-summary-new-mortgage.pdf

Legal Disclaimer: The articles and information provided herein are for informational purposes only and are not intended as a substitute for professional advice. 

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