Debt-to-income ratio: What it is and why it matters
If you’re considering taking out a loan or applying for a credit card, you may have heard the term “debt-to-income ratio” come up. This ratio is an important factor that lenders use to determine your creditworthiness and ability to repay your debts. Understanding what it is and how it’s calculated may help you make informed decisions about your finances and borrowing money.
What you need to know about DTI
- Your debt-to-income ratio is the percentage of your monthly income that goes toward paying off your debts.
- Lenders use this ratio to assess your ability to manage your debt and make timely payments.
- A low debt-to-income ratio may lead to better interest rate offers or better loan terms from lenders when you’re looking to borrow money.
What is the debt-to-income ratio?
Your debt-to-income ratio (DTI) the percentage of your monthly income that goes toward paying off your debts. This includes any recurring debts, such as credit card payments, car loans, and student loans. Lenders use this ratio to assess your ability to manage your debt and make timely payments. A high debt-to-income ratio may indicate that you are having struggles making monthly payments, while a low ratio suggests that you’re in a more manageable financial position.
To calculate your DTI, add up all your monthly debt payments, including credit card bills, auto loans, student loans, and mortgage payments. Then, divide that total by your gross monthly income. The result is your DTI, expressed as a percentage value.
For example, if you have $2,000 in monthly debt payments and $6,000 in gross monthly income, your DTI would be 33% ($2,000 ÷ $6,000). A lower DTI suggests that you may have more disposable income and are less likely to default on your debt.
Calculating debt-to-income ratio
The formula to calculate your DTI ratio is as follows:
DTI ratio = (Total monthly debt payments ÷ Gross monthly income) × 100
Example: Let’s consider a person who has $1,500 in total monthly debt payments and earns a gross monthly income of $5,000.
DTI ratio = ($1,500 ÷ $5,000) × 100 = 30%
In this example, the individual’s debt-to-income ratio is 30%.
It’s important to note that your DTI is just one factor that lenders consider when evaluating your credit profile. They may also look at your credit score, employment history, and other factors. However, maintaining a low DTI may help increase your chances of obtaining a lower interest rate on a new loan or credit card.
What debt counts?
When calculating your debt-to-income ratio, not all types of debt are considered. To better prepare for a loan application, you may want to review what is and isn’t included in this ratio so you can accurately assess your financial situation.
Types of debt that count towards your debt-to-income ratio
- Mortgage debt: The monthly payments on your mortgage loan, including principal, interest, taxes, and insurance (commonly referred to as PITI) are usually the largest component of your debt-to-income ratio. Both primary and secondary mortgages are generally considered in the calculation.
- Consumer debt: Consumer debt encompasses debts related to personal expenses, such as credit card balances, personal loans, and store credit accounts. These debts are essential for evaluating your financial health, as they reflect your ability to manage everyday expenses and discretionary spending.
- Auto loan debt: Monthly payments on auto loans, including both new and used vehicles, factor into your debt-to-income ratio. Lenders may consider the amount owed, interest rate, and remaining repayment term when determining the impact auto loans have on your overall DTI ratio.
- Student loan debt: Student loan debt counts towards your debt-to-income ratio for both private and federal loans. The amount you owe and the monthly payments required are included in the calculation. If you have a deferment or income-driven payment plan, the lender may use the standard payment amount for calculation purposes.
- Other installment loans: Any other loans you have, such as personal or installment loans for home improvements or debt consolidation, are typically considered in your DTI ratio.
Debt that does NOT count towards your debt-to-income ratio
While the above types of debt play a significant role in the debt-to-income calculation, certain debts are not included:
- Utility bills: Monthly utilities such as electricity, water, and gas bills, are not generally factored into your debt-to-income ratio. These expenses are considered as recurring monthly payments but not classified as traditional debts.
- Medical bills: Unpaid medical bills are not typically considered in DTI calculations, although some lenders may consider them informally during manual underwriting processes.
- Insurance premiums: Regular insurance premiums including health, life, or auto insurance are not counted towards your debt-to-income ratio.
Even though these payments are not typically considered by lenders when you are applying for a new loan or line of credit, it is still important to evaluate their impact on your overall budget. Once you receive funds from a loan or start making purchases on a credit card, you will be responsible for making regular payments on principal and interest until you pay it back. Make sure to leave enough room in your budget to stay current on all monthly payments, including for your new loan, as well as to be able to afford any emergency expenses.
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What should your debt-to-income ratio be?
In general, the lower your DTI ratio is, the better. This ensures that you won’t overextend your finances and end up owing more than you can pay and may help build healthy spending habits. Many lenders typically require a DTI of 43% or below to qualify for a loan or mortgage, although there may be instances where a lender will require a lower DTI. You may also be able to find lenders who are willing to work with borrowers with higher DTI ratios, depending on other factors such as credit history and income stability.
However, if your DTI is higher than 43%, it might be particularly important to work on reducing it before you try to acquire a mortgage loan such as a home equity loan or home equity line of credit (HELOC). This is because these types of loans are secured using your home as collateral — meaning if you can’t make regular payments on these loans, you run the risk of foreclosure.
Tips to improve your debt-to-income ratio
You can lower your DTI in a few ways — the easiest of which may be paying down debts and reducing or eliminating additional monthly debts.
- Reduce your debt: Paying down existing debts helps lower your total monthly debt payments, subsequently improving your DTI ratio. Your DTI looks at monthly payments, not your total amount of debt, so one solution may be to prioritize the reduction of debt by focusing on the highest monthly payments first.
- Increase your income: Bringing your DTI down requires you to reduce your debts or increase your income (or do both!). Exploring opportunities to increase your earning potential such as taking on additional work or seeking promotions may help improve your DTI ratio.
- Avoid taking on new debt: Minimizing the amount of new debt you incur will prevent your total debt from increasing and help your DTI ratio stay stable or potentially improve.
- Refinance or consolidate debt: Consider refinancing high-interest loans or consolidating multiple debts into one to potentially reduce monthly payment amounts and improve your ratio.
- Increase your repayment time: Contacting lenders to see if it may be possible to lengthen repayment terms may help reduce monthly payment amounts.
- Make extra payments: By making more than the minimum required payment each month, you may pay down your loan balances faster and reduce the amount of interest charges you pay. In the case of credit card debt, this may mean a lower monthly payment amount. With amortized loans, paying down the balance faster may put you in a better position to refinance or consolidate those loans into a single lower monthly payment.
- Seek professional assistance: Consulting a financial advisor may give you tailored strategies and guidance on managing debt and improving your debt-to-income ratio.