Market Insights

Debt-to-Income: How to Calculate & What it Means

Couple looking at their documents calculating their debt to income ratio

Learning your debt-to-income ratio is an easy way to be more informed of your eligibility for financial products, like home equity loans (HEL). 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 (DTI) ratio is important to lenders, like Discover Home Loans, because it gives an idea of the finances that you can put toward a 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 your DTI. This guide will provide you with a simple look at calculating your DTI ratio, and what it means.

 

What Debt Counts?

Your debt-to-income ratio 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 usually consider 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 usually not considered 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 to Calculate Your DTI Ratio

Now that you have a handle on what to consider, learning your DTI ratio is possible in three easy steps:

 

1. Add up all of your debts that are listed under “debts to usually consider” above. Make sure you don’t include anything in the “payments usually not considered” list.

 

2. Add the expected monthly cost of your home equity loan (HEL) to the total. If you have a desired loan amount in mind, use Discover Home Loans’ monthly payment calculator 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 see it in action. Assume you make $6,000 each month before taxes. Now, let’s assume that your monthly debts and the monthly cost of your HEL would be $2,160. Divide $2,160 by $6,000 and you will get 36%. This means your DTI ratio would be 36%.

 

Now, it’s time to learn which DTIs are the best.

Woman playing with her dog taking a break from calculating her debt to income ratio

In general, the lower the DTI ratio, the better.

 

What Should Your Debt-to-Income Ratio Be?

In general, the lower the DTI ratio, the better. Many lenders require a DTI of 43% or below for a home equity loan. 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 percent, it might be best to work on reducing it before you try to acquire an HEL. You can lower your DTI in a few ways, the easiest of which is paying down debts, such as credit cards, 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.

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 DTI

Bringing your DTI down requires you to either increase your income or reduce your debts. Increasing your income can mean a new job, a promotion, or a second job. Reducing your debts can be more complicated, although it may be achieved through debt consolidation methods. 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 certain debts to pay off with your loan. You should discuss this with your specific lender.

 

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

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