What is Debt-to-Income Ratio? How DTI Impacts Credit and Loan Approval

When I was looking into buying a condo, I got to experience plenty of personal finance jargon and acronyms first-hand. LTV, HOI, and PITI were just a few that I had to deal with.

But one of the most important was DTI, which refers to your debt-to-income ratio. This metric allows lenders to gauge your financial health and, most importantly, your ability to make payments.

While keeping a good DTI can be challenging, understanding the concept isn’t. DTI represents the ratio of your monthly debt payments to your monthly income.

DTI stands for debt to income ratio, and it is one of the primary metrics lenders and creditors use to determine approval. It measures how much available income you have compared to how much debt you owe.

Debt payments used to calculate your DTI include things like rent or a mortgage, auto loans, credit cards, and student loans. And your monthly income is your total pay before taxes. Your debt-to-income (DTI) is the ratio between these debts and your income.

Having a low enough DTI is critical to securing credit and loans for the things you need — in my case, a condo. Lenders often closely consider DTI along with your credit score. If your DTI is high, don’t worry, it’s not set in stone. I can walk you through the ins and outs of DTI and show you some steps you can take to bring your DTI back down to earth.

To get your debt-to-income ratio, just add all your monthly debt payments and compare them to your income. Sometimes that’s easier said than done, especially if you have a lot of debt.

While this is a fairly straightforward calculation, DTI can vary significantly depending on the types of debt you have. In addition, there are multiple kinds of DTI to consider.

How to Calculate DTI

To calculate your DTI, start by listing all your monthly debt payments. You don’t have to include your grocery bills or streaming services, although if those are sky high they will definitely impact your monthly cushion. DTI usually includes rent or a mortgage, auto, student, and personal loans. 

Once you have listed all your monthly debt payments, add them together to get your total monthly debt payments. Then, divide that total by your gross monthly income. Remember, your gross monthly income is your total pay before taxes. And you guessed it, having a higher taxable income can actually improve your DTI.

When lenders see that you use less of your monthly income to pay off debts, that indicates you’ll have an easier time managing a new loan or credit line. As a result, you’ll be more likely to make payments on time. Personally, I like to keep a close eye on my DTI because it reduces my financial stress.

Here are some examples of how DTI calculation might look:

In this example, the borrower has a DTI of 36%, which is generally an acceptable DTI.

In our second example, the consumer has a DTI of 45.6%. Some lenders may decide this DTI is too high. The borrower may need to shop around for a lender that will approve them at their current DTI, or the borrower will need to lower their DTI before they can get a loan or line of credit. Using close to 50% of your income on debt shows you may be a big risk.

Types of DTI

While total debt payments divided by gross monthly income is the simplest way to calculate DTI, it isn’t the only way. Variations of the DTI calculation include front-end DTI and back-end DTI.

Front-end DTI is also known as the housing ratio because it measures the percentage of your gross monthly income that goes toward housing expenses. 

These include rent or a mortgage and expenses like property taxes, homeowners insurance (HOI), and homeowners association (HOA) fees. When I was searching for my condo, I looked for an HOA under $500 per year. The lower the HOA, the better it will be for my front-end DTI. Of course, the same is true for taxes.

Back-end DTI is the ratio of all monthly debt payments to gross monthly income. In other words, back-end DTI is the same as the DTI calculation discussed earlier.

Front-end DTI is usually lower than back-end DTI because it only considers housing payments. However, lenders often use both calculations when deciding whether to approve you for a loan or line of credit, so you may want to check which one a lender uses before you apply.

Generally, the lower your DTI, the better your chances of approval for loans. This is because lenders consider borrowers with a low DTI less risky than those with a high DTI. 

You must fall within certain ranges to have the best approval odds. Remember that DTI isn’t the only factor; lenders will also consider credit scores and other information.

Role in Loan and Credit Card Approval

If your DTI is too high, you may struggle to gain approval from all but the most open-minded (possibly subprime) lenders. That may mean much higher interest rates and possibly even some extra fees.

This is because DTI is seen as a measure of financial health and your ability to repay debts. If your DTI is low, it tells lenders you have a healthy balance between income and debt, making you a less risky candidate.

DTI also helps lenders assess whether you can take on additional debt. They want to ensure you won’t become over-leveraged and default on your payments. In my case, a DTI that is too high would mean that I needed to find a cheaper condo.

Often, lenders have set thresholds you must meet to qualify for a loan or line of credit. These vary by lender, but you likely wouldn’t be approved if you don’t meet them.

In addition, if your DTI is low, you are generally considered less risky. This tends to lead to lower interest rates and better loan terms. You may even get better rates than borrowers with high DTIs even if interest rates are falling. On the other hand, if your DTI is high, you’ll probably face high interest rates and more unfavorable loan terms.

Credit cards work much the same way, although issuers have a little more wiggle room. They may offer borrowers with higher DTIs a lower credit limit to mitigate their risk. 

A lower DTI can mean higher credit limits for credit cards because it shows you have sufficient income to cover your debt repayments. 

I usually try to keep my DTI as low as possible, including my credit card balances. The ratio of your credit card balances to your total available credit is known as your credit utilization ratio, which is a big factor in your credit score. Keeping your credit card balances low can make you a stronger applicant.

Ideal DTI Ratios

The ideal DTI ratio varies depending on the lender and type of loan. However, as a general rule, your front-end DTI (housing ratio) should be 28% or lower. This means 28% or less of your gross monthly income should go toward housing expenses.

A back-end DTI should generally be 36% or lower, but lenders set their own restrictions based on their comfort level.

Based on my research, I can also break out ideal DTI ratios by the type of loan or credit. Here are a few examples:

• Conventional home loans: Front-end DTI should be 28% or less; back-end DTI should be 36% or less.
• FHA loans: Front-end DTI should be 31% or less; back-end DTI should be 43% or less.
• USDA loans: Front-end DTI should be 29% or less; back-end DTI should be 41% or less.
• Auto loans: Back-end DTI should be in the range of 36% to 45%. Some lenders may even accept higher ratios. But they may charge astronomical interest rates.
• Personal loans: Back-end DTI should be between 36% to 40% for the best rates.
• Credit cards: Back-end DTI should be 36% or less. However, the lender will likely consider your overall credit profile, not just DTI.

While these ranges provide general guidelines, individual lenders may use different guidelines. Regardless of the lender, you may experience other consequences if your DTI is high. For example, it can result in an outright rejection of your loan or credit application. 

DTI and Credit Scores

DTI and credit scores are both very important metrics from the lender’s perspective. While there can be overlap, they assess different aspects of your financial health. Your credit score evaluates your creditworthiness based on factors like your payment history, credit utilization, and length of credit history. Meanwhile, DTI assesses your current debt obligations relative to your monthly income.

Given that the two are related but not the same, DTI impacts credit scores but only indirectly. For instance, one component of a high DTI could be high credit card balances. Using a large portion of your credit limit (known as credit utilization) can lower your credit score. My credit card balances have been high at times, which caused my credit scores to drop.

At the same time, having high debt levels can lead to missing credit card payments, further dragging down your credit score. In this case, a high DTI doesn’t cause your credit score to drop, but there is a clear correlation.

There can be a more causal link between DTI and interest rates. For instance, if your DTI is low, a lender may deem you a low-risk borrower, leading to a low interest rate on your loan. Conversely, a high DTI means higher risk and potentially higher interest rates. I have been able to secure favorable interest rates due to my strong credit history and relatively low DTI.

DTI can also have a substantial impact on loan terms. If your DTI is low, you may have an easier time getting approved for a loan than someone with a high DTI. You might also qualify for a higher loan amount than someone with a high DTI.

In addition, you may qualify for more flexible and extended repayment periods than the high-DTI borrower. For loans requiring a down payment, borrowers with a high DTI may need to make a larger down payment than someone with a low DTI.

While acceptable DTI may vary by lender, there are some generally agreed-upon principles. For instance, your back-end DTI should be no more than 36% for the best chance of approval for a conventional mortgage.

If your DTI is too high to be approved for credit or a loan – or your terms are unfavorable – you may need to improve your DTI. The only way to do this is to reduce debt payments or increase income. My strategy was to increase my income, using the extra money to reduce my debt. However, the best approach may be different for you.

Reduce Debt

One of the first things you might consider as you look to reduce your DTI is your debt. Remember, DTI considers your monthly debt payments, not the total debt amount. For example, when my lender was discussing DTI with me, he mentioned my monthly car payment, not how much I owe on the car. This can sometimes mean paying more interest in the long run, but that isn’t always true.

To improve your DTI, one option to consider is refinancing a mortgage or auto loan. Refinancing one or both of these loans can give you the option of a lower monthly payment. This may mean paying more interest over the life of the loan in some cases. 

If interest rates have dropped or your credit has improved, you could qualify for a lower interest rate. This is why a lower monthly payment may sometimes only mean paying more interest.

Another option is debt consolidation, which involves combining multiple loans into a single loan with a lower monthly payment. You may also want to consider a personal loan or a balance transfer credit card.

You can also negotiate with lenders to lower your interest rate or give you more favorable repayment terms. Of course, you may be more successful with this if you have consistently made your payments on time and in full.

Whatever strategy you pursue, having a debt repayment plan is essential. This can improve clarity and focus and help you determine which areas to prioritize, such as high-interest debt. It can also help increase your financial discipline, reducing the chance you will take on additional debt.

Increase Your Income

There are many ways to increase your income, which can reduce your DTI, assuming you don’t take on additional debt. Often, one of the quickest ways to increase your income is through your current job. For example, you can negotiate a raise by researching average salaries for your profession and location and listing your accomplishments.

If this isn’t enough, you can look into industry certifications, degrees, or continuing education to boost your skills and market value. This can lead to new, higher-paying job opportunities with your current employer or elsewhere. In the past, I have job-hobbed to increase my pay, which can be an effective strategy.

Sometimes, you may need to branch out. Consider part-time jobs on the nights and weekends or finding a freelance gig for extra income. Look for freelance gigs that leverage your current skills if possible. I did this with freelance writing before eventually going full-time.

For the best results, you can combine income-boosting opportunities with debt reduction. The concept is simple: use it to pay off existing debt rather than spending your extra income. You can set up automatic payments (or increase existing payments) to match your income increase.

In addition, revise your budget to include your regular income and any additional income you are generating. Allocate a significant portion of your extra income to debt repayment, especially if your DTI is high.

As suggested earlier, prioritizing high-interest debt is always a good idea. This might include credit cards, personal loans, or other high-interest loans. Paying those down will reduce the amount of interest you pay in the long run, freeing up money for other things.

Monitor Your DTI

Regularly checking your DTI helps you monitor your overall financial health. For instance, if your DTI is decreasing, it’s a clear sign that you are managing your money and debt responsibly relative to your income. I always see this as a sign of strong financial health.

In addition, knowing your DTI can help you gauge the likelihood of approval for credit and loan applications. It can also help you spot trends and identify possible areas of improvement. When you know your DTI, you can budget more effectively, making the necessary adjustments and setting realistic goals for savings and investment.

You can also increase your credit score since a lower DTI often means lower credit utilization. Checking your DTI regularly will help you identify areas for improvement, including paying credit card balances.

There are many tools you can use to track your DTI. These can include personal finance apps, spreadsheets, or financial planning software. Although these may not always have a field specifically for tracking DTI, these tools can make tracking your income and debt payments easier, making it quicker and easier to calculate your DTI.

Debt-to-income (DTI) is the ratio of your total monthly debt payments to your gross monthly income. To calculate DTI, add all your monthly debt payments and divide the amount by your gross monthly income, which is your income before taxes and other deductions. 

There are multiple types of DTI, such as front-end DTI and back-end DTI. Front-end DTI only includes housing expenses, while back-end DTI includes all monthly debt payments.

DTI is a crucial figure in personal finance, as it gauges your ability to manage your debts and risk level as a borrower. A lower DTI can increase your likelihood of approval for credit and loan applications and reduce your interest rate, leading to more favorable loan terms. 

If your DTI is high, consider increasing your income by negotiating a raise or working side jobs and reducing your debt through debt consolidation or refinancing your debt.