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When you apply for a loan, like a mortgage, auto loan or personal loan, lenders often want to know how much debt you have compared to how much money you earn. In other words, they want to know your debt-to-income ratio.
Your debt-to-income ratio, or DTI, is a calculation of your monthly debt payments divided by your gross monthly income.
Let’s take a look at how to calculate your debt-to-income ratio, learn why your DTI matters, understand what a good debt-to-income ratio looks like and how to lower your DTI ratio.
- How to calculate your debt-to-income ratio
- Why do lenders care about my debt-to-income ratio?
- When will lenders look at my debt-to-income ratio?
- What is a good debt-to-income ratio?
- How can I improve my debt-to-income ratio?
How to calculate your debt-to-income ratio
To calculate your DTI, add up the total of all of your monthly debt payments and divide this amount by your gross monthly income, which is typically the amount of money you make before taxes and other deductions each month.
Let’s consider an example. Say your gross monthly income is $6,500 and your debt payments total $3,000. Here’s how they break down.
Here’s how you’d calculate your debt-to-income ratio.
$3,000/$6,500 x 100 = 46.2%
Why do lenders care about my debt-to-income ratio?
When a lender considers whether or not to let you borrow money, it wants information about how you handle your finances — both past and present. So lenders will look at different factors — like your credit reports, credit scores and debt-to-income ratio — to get an idea of your financial picture.
When lenders see a healthy debt-to-income ratio, it can help them feel more confident that you’ll be able to make your loan payments. This might help you qualify for financing.
When will lenders look at my debt-to-income ratio?
The process to borrow money differs depending on the type of loan and lender, but in general, lenders want the most accurate picture of your finances they can get before deciding whether to loan you money. This means that your debt-to-income ratio may be part of their calculations.
It can be particularly helpful to know what your debt-to-income ratio is before applying for a mortgage, because mortgage lenders often have strict DTI ratio requirements.
Some mortgage lenders will only consider you for a mortgage if your DTI ratio is under a certain percentage. According to the Consumer Financial Protection Bureau, 43% is typically the highest DTI ratio a borrower can have to get a qualified mortgage. On the other hand, some mortgage loans, such as FHA loans, may allow a higher DTI ratio.
Personal loans and auto loans
With personal loans and car loans, you might be able to qualify for financing with a DTI ratio higher than the typical 43% cap for a qualified mortgage. But you should pay close attention to your interest rate and monthly payment to make sure it’s affordable for you.
Wells Fargo, for example, says that if you have a DTI of 35% or less, you’re probably in pretty good shape.
What is a good debt-to-income ratio?
A lower debt-to-income ratio is a good indicator that you’re able to take on more debt and pay it off.
Keep in mind that any type of debt, including student loans, credit card balances, auto loans, personal loans or mortgages, can increase your DTI ratio — as well as costs like child support or alimony payments.
On the flip side, income from your job, along with any part-time or freelance work and any alimony payments you receive, can count toward your gross income. So it’s important that you keep track of all your debts and income in order to monitor your DTI ratio.
How can I improve my debt-to-income ratio?
There are a number of ways you can try to improve your debt-to-income ratio. The basic idea is lowering your debt or increasing your income. Here are some ideas.
- Pay down debt early. If you have room in your finances, make more than the minimum payments on your debts each month so that you pay them down faster. For example, pay more than your minimum credit card payment every month.
- Cut monthly expenses to pay off more debt. Look at your budget and consider ways you can adjust your spending so that you have more money to use toward debt repayment.
- Consider a debt-consolidation loan. If you can’t make extra payments on your debt or trim your budget, a debt-consolidation loan could be a good option. This may help you reduce the amount of interest you pay while you work to pay down your debts.
- Get a side hustle or ask for a raise. Extra income from side jobs can count toward your income when you calculate your debt-to-income ratio. The boost in salary you’d get from a raise could also help to lower your DTI.
Your debt-to-income ratio is an important number to know if you’re thinking about applying for a loan or other credit.
If your DTI is too high, it can prevent you from getting the loan you want. But if you can come up with a plan to reduce your debt or increase your income, you can work on lowering your DTI, which might improve your chances of qualifying for a loan.