What is a good debt-to-income ratio and why is it important? | Mortgages and Advice

A good debt-to-income ratio is key to getting credit approved, whether you’re looking for a mortgage, car loan, or line of credit. This ratio tells lenders how much debt you have compared to your income.

“The DTI ratio is the ratio of your projected monthly payments to your gross monthly income, expressed as a percentage,” says credit expert John Ulzheimer, formerly of FICO and Equifax.

Bottom line: Your DTI ratio helps a lender determine if you can afford a new loan payment.

Read on to learn more about how to calculate DTI, why you need a good DTI, and if yours makes the cut.

What is a debt to income ratio?

Your DTI ratio is a snapshot of monthly debt versus income.

Your debt includes mortgages, car loans, and credit cards, but excludes expenses like rent, utilities, day care, and car insurance.

What counts as income in your DTI quota? The DTI calculation uses your gross monthly income, or the amount you earn each month before taxes and other deductions. Sources of income can include wages, salaries, tips and bonuses, pensions, and Social Security payments.

Child support and alimony are considered debt when you make those payments and income when you receive them.

Why is your debt to income ratio important?

Your DTI is important because it tells lenders whether you’re managing debt responsibly, and a low DTI ratio can put you in a good position to take on new debt.

Mortgage lenders use DTI to calculate how much home you can buy and whether to approve your loan, says Dave Krichmar, a Houston-based mortgage lender.

A lender may have concerns about your ability to pay off a new loan if you’re struggling with more debt payments than you can comfortably afford. If your DTI ratio is too high, lenders are unlikely to approve you for a loan because they know you’re overstretched and less likely to pay reliably.

How to calculate debt to income ratio

You can calculate your DTI ratio in four steps:

1. Add up your monthly debt payments.
2. Find out your monthly gross income. If your income fluctuates, estimate a typical month’s income.
3. Divide your total monthly debt payments by your gross monthly income.
4. Multiply your answer by 100 to get your DTI ratio as a percentage.

Let’s say your gross monthly income is $7,000 and your debt is $3,000: payments of $2,000 on a mortgage, $500 on a car loan, $300 on a student loan, and $200 dollars for a credit card. Monthly debt obligations of $3,000 divided by monthly gross income of $7,000 is 0.429. Multiply by 100 to get 42.9% or a DTI ratio of 43%.

If you’re looking for a mortgage, use your potential new mortgage payment to calculate your DTI. If you replace your mortgage with another loan, don’t add your old payment to your new one.

The Consumer Financial Protection Bureau has a DTI calculator that can help simplify your math. If you’re not sure how to calculate your DTI, you can also ask an expert for help, such as a mortgage broker or loan officer, says Krichmar.

It’s easy to get confused or look at the wrong numbers, he says. For example, customers have incorrectly used their take-home allowance instead of gross income to calculate DTI, says Krichmar.

What is a good debt to income ratio?

When it comes to DTI, the lower the ratio, the better, says Ulzheimer. “It means you can take on new debt more easily because you have the capacity to make the payments,” he says.

A good DTI ratio is 43% or less, says Krichmar. How do lenders view your DTI ratio?

  • 35% or less: Your score is solid. You most likely have money left over after paying your bills.
  • 36% to 49%: You have room for improvement. You manage your debt well, but a financial emergency could mean trouble. A lower DTI could put you in a better position to borrow or deal with unforeseen circumstances.
  • 50% or more: You have work to do. If more than half of your income goes towards paying off debt, then money is tight. Your borrowing options may be limited because you cannot afford new debt.

How to lower your DTI ratio

To lower your DTI ratio, “either reduce your monthly obligations, increase your gross monthly income, or a combination of both,” says Ulzheimer.

The easiest way to reduce your monthly debt load is to pay off large balances and other balances, says Janice Horan, vice president, Fair Isaac Advisors Global Credit Lifecycle Practice at FICO. “The other option is to make sure you’ve included all sources of income, or make sure you’ve accounted for any recent increases in income,” says Horan.

Krichmar says you can lower your DTI ratio by paying more on your credit card debt or by refinancing loans to reduce your monthly payments.

Other measures that can move your DTI ratio in the right direction:

  • Avoid taking on more debt. New debt can increase your DTI ratio unless you increase your income.
  • Choose a debt settlement strategy. Debt snowball or debt avalanche methods can help, but they’re not your only choice. Depending on your financial situation, you may consider a debt consolidation loan, a balance transfer card, or a debt management plan. Whatever you do, always pay more than the minimum on your credit cards.
  • Look for ways to increase your income. Ask for a raise if you’re overdue, or consider taking a part-time job.

Does Your DTI Ratio Affect Your Credit Score?

Your DTI ratio never affects your credit report or credit score.

“The DTI ratio is not included in the FICO score because verified income is not an available field in the credit bureaus that are the basis for calculating the FICO score,” says Horan.

In general, lenders view borrowers with higher DTI ratios as more risky than their counterparts with lower DTIs, Horan says.

Lenders can reject your loan application if your DTI ratio is too high, or you could end up with a low credit limit and a high interest rate.

When you’ve maxed out credit cards or high balances, they affect your DTI ratio and your credit score, says Krichmar. But “your credit score doesn’t know how much you make,” he says.

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