Your debt-to-income (DTI) ratio is a factor that lenders use in determining whether you’re a good risk for a loan. While this number isn’t directly related to your credit score, it can provide insight into how well you’re managing your debts.
Simply put, lenders see your debt-to-income ratio as an indicator of how likely you are to make the payments on your debt each month.
Your Debts ÷ Your Income = Your DTI Ratio
Calculating your DTI ratio using the debt ratio formula isn’t a difficult task. In fact, you have all of the information you need already at your disposal. Here we’ll show you how it’s done, but Bankrate has a good calculator if you don’t want to do the math yourself. Here are the steps:
- Add up your total monthly debt payments. This includes your mortgage or rent, vehicle loans, credit card payments, student loans – any recurring debt payments that you have. (Do not include utilities, food or other non-debt items)
- Determine your total monthly gross income. That’s the amount you earn before any taxes or other deductions are taken out. Be sure to include all income for the entire month.
- Divide the amount of your total monthly debts by your total monthly gross income. For example, let’s say your recurring debt payments add up to $1,800 each month, and your monthly gross income is $5,000:
- 1,800 ÷ 5,000 = .36 or 36%
So in this case, your debt-to-income ratio would be 36 percent. But what does that really mean, and is this a good debt ratio?
Here’s What Your Debt-to-Income Ratio Should Be
Now that we have a debt-to-income ratio definition, we need to know what lenders consider to be a good debt ratio number.
Obviously the lower your monthly debts are, the lower your DTI number will be. But how high can it be before lenders raise an eyebrow? That’s the question most of us want to know.
According to the Consumer Financial Protection Bureau, a 43-percent DTI ratio is the highest a consumer can have and still qualify for a government backed mortgage.
However, most banks and lending institutions state that DTI ratios higher than 36-percent would be cause for denying a loan.
How to Reduce Your DTI Ratio
If you find that your debt-to-income ratio is higher than you’d like it to be, there are obviously only two things you can do about it.
- The first is to increase your monthly income – and maybe asking for a raise is worth considering.
- The second is to lower your total monthly debt amount. It’s this second option that many people find the most effective.
You can bring your DTI down to a more desirable level if you can pay off a debt or to lower your total monthly debt obligations by even a hundred dollars.
Keep in mind that your debt-to-income ratio is an important factor that lenders consider. The lower the number, the more likely you are to get the loan and a better rate. It’s a good thing to periodically check this ratio on your own using the formula above.
If you find that your DTI ratio has become too high, work to bring it back in line. You’ll find that it can make all the difference when it comes time to apply for a mortgage or a major loan.