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Although your debt-to-income ratio (also known as your DTI ratio) doesn’t directly affect your credit scores, it’s a key component of your credit health and can play a role in your credit application when you are applying for a major loan or mortgage.
Let’s look at some common questions many people have about their debt-to-income ratio. We’ll also review how your debt-to-income ratio may affect your credit health.
- What is my debt-to-income ratio?
- How does my debt-to-income ratio impact my credit?
- What if my debt-to-income ratio is too high?
Your debt to income ratio helps lenders evaluate how much additional debt you can handle and how much of a credit risk you pose.
It’s generally calculated by first adding up all your monthly debt obligations. These may include your monthly credit card payments; student, auto or personal loan repayments; and other financial obligations such as alimony.
You then divide the sum by your monthly before-tax income.
Your income isn’t reported in your credit reports, so as part of a loan application, lenders will often request either a self-reported estimate or documentation confirming income.
Although your debt to income ratio isn’t one of the key factors that calculate your credit scores, it can have a significant impact on your ability to get credit.
For certain loans like mortgage loans, lenders scrutinize your debt-to-income ratio when you are applying for credit because it helps them evaluate your ability to repay your debts. Lenders tend to set your interest rates according to the risk you pose.
If your debt to income ratio is low, then you are more likely to have the income necessary to repay your debts. If your DTI ratio is high, then you may be overwhelmed by debt and unable to pay back new debt obligations. The standard rule of thumb is that your DTI ratio should be less than 36% . Keep in mind that a DTI ratio as high as 36% could put you at risk of paying higher interest rates or being denied altogether. The Consumer Financial Protection Bureau also highlights 43%t as an important number because it is generally the highest debt-to-income ratio a consumer can have while still being eligible for a Qualified Mortgage.
If you want a quick picture of what your debt to income situation should generally look like, try this simple calculation. Approximate your monthly gross income and multiply that number by 36%.
For example, if you have a $2,200 monthly gross income …
$2200 (Gross monthly income) X .36 (Generally recommended maximum DTI) = $792 (Amount your total monthly debt payments should generally not exceed)
This calculation gives you a quick guideline of what a comfortable debt load looks like for your monthly income.
If your debt-to-income ratio is higher than you’d like, the two ways to lower it are to increase your income or lower your debt payments. With extra time, you may be able to take on a second job. Already doing well at work? Try making a case for a raise. To lower your total monthly debt payments, consider fully paying off loans or credit cards, refinancing your loans to lower your individual monthly payments or consolidating your debt.