When learning about credit, borrowers may come across many new terms and phrases. One of these is the debt-to-income ratio, or DTI ratio. This is an important term to understand because your DTI ratio is a significant indicator of your credit health. Learn what the DTI ratio is, how to calculate it and why it’s important to your future borrowing activities.
What Is Debt-to-Income Ratio?
Your DTI ratio is a number that represents your total monthly debt payments divided by your total gross (before tax) monthly income.
How to Calculate Your DTI Ratio
To calculate your DTI ratio, simply add up all of your monthly debt. Then add up all of your monthly pre-tax income. Divide your debt payment by your total income. The number you get is your DTI ratio.
For example, if you pay $1,500 monthly for your mortgage payment, $200 monthly for a car loan and $300 monthly for your student loan, your total monthly debt is $2,000. If your total monthly income is $6,000, then your DTI ratio is 33 percent (that is, 2,000/6,000).
If math isn’t your strong suit, there are several online DTI ratio calculators that will do the work for you. Try Credit.com’s Debt-to-Income Ratio Calculator or Zillow’s Debt-to-Income Calculator. Whether you use a pencil and paper, a handheld calculator or an online DTI ratio calculator, gather all your information before you begin. You may need some or all of the following:
- Mortgage payments
- Loan payments
- Credit card balances
- Credit line payments
- Any other debt
When Lenders Use Your DTI Ratio
Lenders may look at your DTI ratio when you apply for a new mortgage or loan. While it isn’t the only thing they’ll consider before approving or denying your application, lenders may review your DTI ratio along with other information such as your credit report to assess the potential risk of lending you money.
What’s a High DTI Ratio?
A high DTI ratio indicates that debt payments consume a larger portion of income. If you have a high DTI ratio and lose your income or take on additional debt, you might have a hard time paying the mortgage or loan being considered. However, a lower DTI ratio suggests you have greater income capacity to make your payments.
Generally, qualified borrowers with DTI ratios below 36 percent may be offered the best rates and terms on loans and mortgages, while higher DTI ratios may mean higher rates or even not qualifying for a loan. If you’re hoping to get a Qualified Mortgage, aim for a DTI ratio at or below 43 percent.
How Your Debt-to-Income Ratio Improves
The three ways to improve your DTI ratio are simple:
- Your income increases.
- You reduce your debt.
- Both happen simultaneously.
Though these steps sound simple, improving your debt-to-income ratio may challenge those people who have difficulty sticking to a budget, or who get tempted to spend more than they can afford. For more tips and information on how to improve your own financial situation, find additional budgeting tips.