We all know that having access to credit is a necessary part of life. Being able to effectively and responsibly manage that credit, however, isn’t always an easy task. Circumstances make it hard to pay off balances in full each month, particularly on credit cards, and the need for a loan can arise nearly anytime.
When you have debts you are paying each month, you may inadvertently have a high debt-to-income ratio. This can put a damper on your financial life without you even knowing it. Here’s what you need to know about your debt-to-income ratio, and why it matters so much.
What is Debt-to-Income?
Debt-to-income, or DTI for short, is a ratio that compares your monthly income to the debt payments you owe each month. Included in a debt-to-income ratio calculation are student loan payments, auto loans, child support, mortgage payments, and credit card payments. What’s not included are regular monthly bills, such as utilities, insurance, childcare, or groceries. Your debt-to-income ratio is used by lenders to determine how much you have on your financial plate each month – and if you’re able to add another obligation.
Calculating Your Debt-to-Income Ratio
Figuring out what your debt-to-income ratio takes a few steps, starting with adding up your monthly debts. These will include monthly housing payments, minimum credit card payments, and minimum loan payments from all sources. Remember to also add in other required obligations, like alimony or child support, should those apply to you.
Once you have this number, you then need to add up your monthly income. Here, we are looking at gross income, so the amount received before taxes are accounted for. For most, this figure includes salary from work, tips and bonuses, pension payments, social security income, and child support or alimony.
Take the total debt number divided by your gross monthly income to get your debt-to-income ratio. For instance, if you have total debt obligations of $2,000 per month, and gross income of $5,500, you take $2,000 / $5,500 to get .3636. Convert this to a percentage, 36%, and you’ve got your debt-to-income ratio.
Why DTI Ratio Matters
Your debt-to-income ratio is an important metric in your financial life, for a few reasons. First and foremost, lenders use this calculation to determine how much new debt you can take on without putting a strain on your budget each month. They want to feel confident that if they approve a new loan, such as a mortgage, you have enough to cover all your debt obligations, including the new mortgage payment, as well as money to spend on other non-debt items. A high debt-to-income ratio indicates to a lender that you may be a high risk for default.
The DTI calculation also plays a role behind the scenes, although not directly. Credit utilization is a factor used to calculate your credit scores with the three main credit bureaus – Equifax, Experian, and Transunion. A high credit utilization, while not directly tied to your income, can lead to a lagging score. This, then, results in more challenges when getting a new loan or credit card, and of course, it increases how much you are required to pay each month on debts owed.
Lenders looking at your debt-to-income ratio want to see a low number, but some may have more lenient standards for this measurement of financial health. For instance, a mortgage lender may allow a DTI of up to 50%, while others may cap the ratio at 43%. Understanding what your debt-to-income ratio is, along with knowing what your lender requires, is an essential component of getting approved for a new loan with the most affordable terms.
Improving Debt-to-Income
If you have a high debt-to-income ratio, don’t fret. There are several steps you can take to bring that percentage down. Here are some of the most common:
Pay down existing balances
The best move you can make toward lowering your debt-to-income ratio is to pay down existing balances on your debts. Focus on paying more than the minimum when possible, particularly on credit cards.
Increase your income
Another common strategy to improve debt-to-income calculations is boosting income. This can be done, in some cases, with an additional part-time job or a side hustle, but know that not all lenders will take these income sources into account. Be sure to ask before moving in this direction, and know that focusing on long-term debt repayment and reduction is your best bet.
Minimize new credit card charges
Adding to your debt load, especially right before applying for a new loan, isn’t going to help bring down your debt-to-income ratio. If possible, limit how much you are adding to a debt balance each month, and hold off on big purchases if possible.
Refinance current debts
Another way to reduce your DTI is to refinance loans with an extended repayment period. Student loans, auto loans, and personal loans may all be refinanced so long as you have a healthy credit score. Refinancing to a longer term does not help on the debt repayment front from a timeframe perspective. It does, however, lower your monthly payment which ultimately brings your DTI down.
Final Thoughts on Debt-to-Income Ratio
Your debt-to-income ratio is a crucial component of your financial life, even if you don’t realize it. Lenders look to this measurement to determine whether or not you can afford to take on new debt like a mortgage or car loan, so be sure to know how to calculate it. If you have a DTI above 43%, think about which tips you can implement to starting bringing that number down.
