Debt-to-Income (DTI) ratio: How to calculate & what it means
Learning your debt-to-income ratio is an easy way to be more informed of your eligibility for financial products, like a home equity loan from Discover® Home Loans. It plays an important role in understanding your overall financial health because it compares what you earn to what you owe.
The debt-to-income ratio is important to lenders because it gives them an idea of the room you have in your finances to put toward a new loan. DTI plays a role in how much you can borrow, what monthly payments you may be able to afford and what the final structure of your loan might be.
You can empower yourself during the process of obtaining a home equity loan for home improvements, debt consolidation or paying major expenses by learning about your DTI. This guide will provide you with a simple look at calculating your DTI ratio, and what it means.
What debt counts?
The debt-to-income ratio formula is a straightforward calculation.
It looks at your existing debt payments, as well as the projected payment for your new home equity loan and identifies what percentage of your total pre-tax income these represent.
Debts to consider usually include:
- Current mortgage payment, including any fees such as taxes, HOA or condo dues and insurance
- Credit card debt
- Car loans
- Student loans
- Other existing loans and debt
Payments not considered usually include:
- Living expenses, such as your grocery bills
- Utilities, such as water and electricity
- Monthly service bills, like your cell phone, TV packages and internet
3 steps in the debt-to-income ratio formula
Now that you have a handle on what to consider, learning your DTI ratio is possible in three easy steps:
1. Add up all your payments towards the debts that are listed under “debts to consider” above. Make sure you don’t include anything in the “payments not considered” list.
2. Add the expected monthly payment for a new loan like a home equity loan to the total from step 1.
If you have a desired loan amount in mind, use the monthly payment calculator from Discover Home Loans to get an estimate for your monthly payment and APR.
3. Divide your total from step 2 by your pre-tax income. This will give you a percentage, which is your DTI ratio.
Let’s look at an example.
Assume you make $6,000 each month before taxes. Now, let’s assume that your monthly payment towards your debts plus the expected monthly payment of your home equity loan is $2,160. Divide $2,160 by $6,000 and you will get 36%. This means your DTI ratio with the new loan payment is 36%.
In general, it’s better to have a lower debt-to-income ratio.
What should your debt-to-income ratio be?
In general, the lower your DTI ratio is, the better. Many lenders require a DTI of 43% or below for home loan products, including home equity loans. This ensures that you won’t overextend your finances and end up owing more than you can pay. This helps create healthy debt and income habits.
If your DTI is higher than 43%, it might be best to work on reducing it before you try to acquire a home equity loan. You can lower your DTI in a few ways—the easiest of which is paying down debts and reducing or eliminating additional monthly debts.
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.
Paying down debt that doesn’t change its monthly amount based on the total owed doesn’t help in the short term, but it is a great part of a long-term strategy for reducing debt and making the most of your home and its value.
How to improve your debt-to-income ratio
Bringing your DTI down requires you to either increase your income or reduce your debts.
Increasing your income can mean getting a new job, a promotion, or a second job. Reducing your debts can be more complicated, although it might be achieved with debt consolidation opportunities. By consolidating your debts through a new loan or line of credit, you may be able to reduce monthly payments on your debt, which can help to reduce your DTI. Your lender may be able to help you reduce your DTI by suggesting that you pay off certain debts with a new loan intended for debt consolidation. Be sure to discuss this with your specific lender to find out what might work best for you.
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