Often, the first time many people hear the term “debt-to-income ratio” is when they apply for credit or a loan. Your debt-to-income ratio (also known as DTI) is an important indicator of your financial health and can monitored to help set and achieve financial goals. When you apply for a loan, lenders may look at your DTI to help them determine if you will be able to manage monthly payments.
“Your debt-to-income ratio is a measure of your creditworthiness,” says Luke Delorme, director of financial planning for American Investment Services in Great Barrington, Mass. “The more your debt servicing costs, the less creditworthy you are.”
How to calculate your DTI
A DTI ratio compares your monthly recurring payments to your gross monthly income. To estimate your DTI, you can use an online debt-to-income calculator or pencil and paper.
First, gather your bills. You’ll need to include any of the applicable items:
- Full mortgage payment (including principal, interest, taxes, insurance and any homeowner association fee) or rent payment
- Car payment
- Student loan payment
- Personal loan payment
- The minimum required payment on all credit cards or lines of credit
- Child support or alimony payments
Then, figure out your gross household income from pay stubs and other documented sources of income, such as self-employment or company pay stubs.
Your ratio is your total included spending divided by your gross income.
For example, if your recurring expenses total $2,500 per month and your gross monthly income is $7,000, your DTI would be 36 percent.
“You don’t need to include your discretionary spending or things that fluctuate such as your gas bill or groceries,” says Trey Peterson, an associate with the Haven Financial Group in Burnsville, Minnesota.
Why DTI matters
Your DTI provides an immediate snapshot of your finances.
“If your DTI is too high, this can be an indication that your debt is consuming too much of your income,” says Delorme. “It can be hard to cover your daily expenses and it can hurt your quality of life if you have too much debt.”
Peterson recommends that everyone work toward lowering their DTI and eliminating debt other than a mortgage or rent payment and perhaps a car payment. One way to start is to consolidate the balances from higher-interest debt such as department store credit cards into a lower, fixed-rate personal loan.
“If you can reduce your debt, you’ll have more flexibility and freedom,” he says.
While knowing your DTI is important for personal reasons, it’s also essential information for creditors. Your DTI ratio can make the difference between a loan approval and rejection because it’s a strong indicator of whether you can afford to add new payments to your monthly budget. If your DTI is too high, you could hurt your chances of buying a home or a car or getting approved for a loan.
What’s a good DTI?
Ideally, you want your DTI to be as low as possible since that indicates that your income is well above what you need for recurring expenses, says Delorme.
“A 30 percent DTI would be a reasonable target, but it all depends on the circumstances and an individual’s comfort level with debt,” says Delorme. “Banks generally look at 43 percent as the maximum DTI before your creditworthiness starts to drop off.”
If you’re applying for a personal loan, lenders typically want to see a DTI of 35 to 40 percent or less, but some exceptions can be made to allow a higher DTI if you have good credit. Studies have shown that borrowers with a DTI above 43 percent have more difficulty paying their bills.
Lowering your DTI
To change your DTI ratio, you’ll need to reduce your debt payments, increase your income or do both.
“I worked with a couple recently whose DTI was too high to buy a house,” says Peterson. “The first step was to create a budget based on their net income minus their savings. We made a list of all their recurring payments and they were able to eliminate about $450 per month without a major lifestyle change by doing things like having their adult kids pay their own cell phone bills and eliminating their cable bill.”
If you have higher-interest debt, a personal loan could help you save money by consolidating those bills into one fixed-rate loan and set monthly payment. If you get a personal loan at a lower interest rate than you had been paying, you’d reduce your overall debt load, which in turn could get you a more favorable DTI.
Lenders like Discover may allow you to choose the target date for your loan payoff and repayment term that fit your budget. Discover Personal Loans, for example, offers a variety of repayment terms, from three to seven years.
Another alternative that Peterson recommends is the “debt snowball” approach, which means you pay off the debt with the largest balance first and then move onto the next.
Eliminating High-Interest Credit Card Debt
Credit cards can serve an important role in building credit as well as providing a convenient payment option in daily life. If you find yourself struggling to keep up with payments on credit cards with high interest rates and few rewards, however, it may be time to reevaluate how you manage this type of debt. “Eliminating credit card debt should be a top priority,” says Delorme. “You don’t want to have even a small amount of debt at 20 percent interest.”
“It’s all about the interest rate,” he says. “It’s better to use a personal loan with a lower interest rate to pay off a credit card with a 20 to 25 percent interest rate than to just keep paying the credit card.”
“You need to compare interest rates, loan terms and the monthly payment to see the impact of consolidation using different methods,” says Peterson
For example, a personal loan for $10,000 for a borrower with a FICO®credit score between 740 and 799 at an interest rate of 11.99 percent for 29 months would save a borrower $1,480 and debt could be paid off 4 months sooner. That same amount in credit card debt at a 20 percent interest rate, with a minimum payment requirement of 4 percent, would require a monthly payment of $400 initially and would take 13 years and 9 months to repay and incur $6,356 in additional interest. If you’d like to calculate how much you could save on interest on your higher-interest debt try our debt consolidation calculator.
Your DTI ratio is an indicator of your financial health. Improving it might it easier to qualify for credit, and it could also set you on the path to a stronger financial future.