Most lenders consider a good debt-to-income ratio or DTI to be 35% or less. Your DTI is calculated by adding up the minimum debt payments you owe each month and dividing the figure by your gross monthly income.
When you apply for a credit card or loan, lenders evaluate your credit history and debt-to-income ratio to approve or deny your application. This article outlines exactly what determines your debt-to-income ratio, the guidelines creditors use, and how to improve your DTI.
A person’s debt-to-income ratio is calculated using two things:
It does not include the total amount you owe to lenders but rather your monthly minimum payments.
Let’s say you have a mortgage with an outstanding balance of $150,000. Your required monthly payment is $800. It’s the $800 that gets factored into your DTI, not the $150,000.
It’s also your gross monthly income lenders use, not your take-home pay after taxes and deductions. Earning a yearly salary of $60,000 translates to a gross monthly income of $5,000. But if you have income from a side hustle or second job, that counts too.
First, add up all of your monthly minimum payments from personal loans, mortgages or rent, credit cards, and student and car loans. Second, figure out your gross monthly income from jobs, investments, business interests, and other sources like alimony.
For example, someone has a mortgage payment of $1,500, a $350 car payment, and $100 to pay toward student loans. Their total monthly minimum payments are $1,950.
That same person earns $4,000 a month from a full-time job. They also freelance on the side, bringing in an additional $2,500 a month. Their combined gross monthly income is $6,500.
Dividing $1,950 by $6,500 results in a DTI of 30%. If they were to pay off their student loans, the monthly debt obligation would decrease to $1,850. As a result, the individual’s debt-to-income ratio would decrease to 28.5%.
Individual creditors set separate debt-to-income guidelines and acceptable ratios. Acceptable DTI ratios can even vary between different financial products issued by the same lender. For instance, the cutoff might be lower for a mortgage than it is for a secured credit card.
Generally speaking, you’ll want your debt-to-income ratio to be 43% or less if you want to qualify for most mortgages. However, it’s better if you can lower your DTI to 36% or less.
Most mortgage lenders want to see no more than 28% to 30% of your monthly gross income go toward your payment. So, you’ll want to aim for 6% to 8% of your income to go toward other debt like credit cards and vehicle loans.
If you’re interested in applying for a mortgage or another line of credit with a specific lender, it’s best to check their guidelines.
However, you may need to abide by additional requirements, such as submitting proof of savings or obtaining a co-signer. If your debt-to-income ratio is higher than 49%, you may not get approved for a mortgage or unsecured credit cards.
Lenders look at applicants’ DTIs because it indicates whether they have the funds to pay back a loan or revolving debt. The lower a person’s debt-to-income ratio, the more discretionary income they have. And usually, fewer debt obligations mean they can build up wealth and savings.
A lower debt-to-income ratio also means an applicant has wiggle room to comfortably take on another loan. Applicants with higher DTIs are more likely to default on their monthly payments and the loans themselves. These individuals are at a higher risk for lenders.
Let’s take the example of an applicant with a 50% debt-to-income ratio. This individual already has half of their gross monthly income spoken for. Additional debt and required monthly payments will put more financial strain on this person than on someone with a DTI of 30%.
A lender knows that if a person with a DTI of 30% has a health or financial emergency, they stand a better chance of managing existing debt and a one-time hospital or car repair bill. Plus, any new loans aren’t factored into an existing debt-to-income ratio.
So, if an applicant with a 50% DTI and a monthly gross income of $5,000 is applying for another loan, their debt-to-income ratio will increase. A new loan with a monthly payment of $1,000 will increase that person’s DTI to 70%.
The same circumstances with an applicant with a 30% DTI will result in a new debt-to-income ratio of 50%. Neither is ideal, but the applicant with the lower DTI is more likely to get approved.
You can improve your debt-to-income ratio in two ways: increase your income or reduce your debt. Some people do both, especially if they’ve just graduated from college or are starting out in a new career. Taking on a second job or side hustle is easier than moving up the ladder.
Managing your debt from the start can help, but not everyone can avoid student loans, other types of loans, and revolving credit card balances. However, if your debt balances are high, it’s never too late to start reducing them.
One popular technique is known as the debt snowball method. This involves listing all of your outstanding debt and the balances. You arrange the balances from lowest to highest.
Then, you list the minimum monthly payments on each of the obligations. Moving forward, you pay only the minimum amounts on all the balances except the lowest one. You pay the most you can each month on the lowest balance until it’s paid off.
Once that balance is paid, you add what you were paying on it to the next balance. This payment is in addition to the minimum you’re already sending in. You keep doing this with subsequent balances until everything is paid in full.
Here’s a simple illustration. You have a student loan with a $5,000 balance and a $50 monthly minimum payment. There’s also a car loan with a $10,000 balance and a $150 monthly minimum payment.
Finally, you have a credit card balance of $15,000 that you must pay $50 a month on. You can afford to devote $350 each month to debt payments. Instead of $50, you start paying $150 every month toward your student loan.
You keep paying $150 for your car and $50 for your credit card. Once your student loan balance is gone, you start sending in $300 a month for your car loan. And after that balance is wiped out, you devote the full $350 to your credit card.
As you’re probably aware, lenders also pull your credit history and score when you apply for a mortgage or loan. Once you have a loan or credit card, the lender may also periodically review your report for new information.
While your credit score can impact the interest rate you qualify for and whether you get final approval, your DTI does not directly influence the score. Factors like your payment history determine your score, your use of credit, and how long you’ve had your accounts open.
Your debt-to-income ratio can indirectly influence your credit score. This is because your outstanding debt balances each month help determine your score. Your credit utilization percentage is calculated by how much of your available credit you use.
If you have one credit card with a $6,000 limit and an outstanding balance of $3,000, your credit utilization is 50%. High balances in proportion to your limits can lower your score, especially if you don’t pay them off and carry them over from month to month.
The types of credit you take out can also impact your score. A good mix of revolving and installment debt is usually a better sign. Installment debt comes with a fixed term, outstanding balance, and payments. Mortgages and car loans fall into this category.
Revolving accounts are things like credit cards that let you make new monthly charges. You don’t have to make new charges, but you also don’t have to pay more than the minimum payment.
To help raise your score, paying outstanding credit card balances in full each month is common practice. If possible, don’t charge more than you can afford to pay off each month.
Most financial experts and credit reporting agencies recommend not exceeding a 30% credit utilization rate. This includes all revolving account balances. If your combined credit limits between accounts are $9,000, keep your total balances to $2,700 or less.
However, there are some exceptions to the rule. A person with a good to excellent credit score can occasionally get away with using more than 30% of their available limit. They’re not going to have as much of a ding on their score as someone who consistently uses 50% or more.
Plus, credit utilization can vary widely from month to month. You might not use any of your limits for three months and then suddenly need to use 50% because of an unexpected expense. Then the next month, you only use 20%.
Keeping your accounts in good standing and paying them on time is more important. Aim for a credit utilization rate of 30% or less, but don’t stress if there are a few times when you need to tap into your limits a bit more.
You can also ask creditors to raise your limits if you can comfortably pay the balances.
Your debt-to-income ratio doesn’t tell the entire story behind your financial obligations. For instance, the ratio doesn’t account for the type of debt or what it’s costing you. Some financial experts advocate for student loan debt and mortgages since they’re an investment in yourself.
A home typically appreciates in value, helping you to build wealth. In most cases, you can wipe out a mortgage’s remaining balance and then some by the time you sell.
Taking out student debt also usually results in a degree that can open up more professional opportunities and lifetime earning power. While there are exceptions, statistical averages show that people with a bachelor’s degree earn $32,000 more than high school graduates.
The average annual earnings for high school graduates are $30,000. Workers with undergrad degrees earn an average of $44,000 per year in their first year out of college. Student loan and mortgage interest rates also tend to be lower than other forms of debt.
Graduating with a high amount of student loan debt or buying a house in a market where home prices are high can create higher DTIs. However, these higher debt-to-income ratios don’t necessarily mean the individual is in trouble or will remain overextended.
Some lenders will extend smaller personal loans to applicants with a higher DTI. These creditors take on borrowers with more risk. These types of loans can be a lifesaver for people who encounter emergencies.
If you only need to borrow $1,000 to get your car out of the shop or pay the hospital for medical tests, it can be more favorable than using a credit card.
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