While your debt to income (DTI) ratio is a key component of your credit health, it doesn't directly affect your credit score. It does, however, play a role in your credit application when you are applying for a major loan or mortgage.
What is My Debt to Income Ratio?
Your DTI ratio helps lenders evaluate how much additional debt you can handle and how much of a credit risk you pose. It is calculated by dividing your monthly income by your total monthly debt payments, including minimum credit card payments, auto loan and student loan payments and any other regular debt obligations. Your income isn't reported in your credit report, so the lender will often request either a self-reported estimate or documentation confirming income.
While your DTI ratio isn't one of the five key factors that calculate your credit score, it has a significant impact on your ability to get credit.
How Does My DTI Ratio Impact My Credit?
Lenders scrutinize your DTI ratio when you are applying for credit because it's an indicator of your ability to repay your debts. Lenders tend to set your interest rates according to the risk you pose.
If your DTI ratio is low, then you are likely to repay your debts because you have the income available. 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 percent, as lenders generally require that borrowers have a DTI ratio no higher than 40 percent in order to qualify for a mortgage. A DTI ratio as high as 36 percent puts you at risk of paying higher interest rates, or being denied altogether. Note that some types of mortgages will allow a DTI ratio above 40 percent, such as Federal Housing Authority mortgages and Veterans Administration mortgages.
If you want a quick picture of what your debt to income situation should look like, try this simple calculation. Approximate your monthly gross income and multiply that number by 36 percent. For example:
$2200 (Gross monthly income) X .36 (Percentage that your DTI ratio should be below)
= $792 (Amount your total monthly debt payments should not exceed)
This calculation gives you a quick guideline of what a comfortable debt load looks like for your monthly income.
What If My DTI Ratio is too High?
If your DTI Ratio is too high, you can either increase your income or lower your total monthly debts. You may be able to increase your income by taking on second job, getting a raise, or finding alternative streams of income such as starting a small business. To lower your total monthly debt payments, fully pay off loans or credit cards, refinance your loans to lower your individual monthly payments, or attempt debt consolidation.