Your debt-to-income (DTI) ratio is considered when looking at your overall financial health aside from your credit score. Knowing how to calculate it can help you with your decision whether or not to apply for credit or a loan or learn how comfortable you are with your current debt. This ratio is expressed as a percentage.
Lenders view consumers with higher DTI ratios as risky borrowers. They use this percentage to evaluate and determine whether or not to approve you for a loan. They use this to gauge how well you manage monthly debts and if you can actually afford to pay a loan back.
In this article, we’ll teach you how to calculate your debt-to-income ratio, what debt factors make this up, and what you can do right now to improve this ratio to help your financial situation.
The Importance of Debt-to-Income Ratio
A low debt-to-income ratio displays a good balance between an individual’s income and debt. A high DTI ratio simply means that you have too high of a debt for the amount of income you earn monthly.
Lenders plainly view it this way: if you have a low DTI ratio, you are more likely to effectively manage paying off your monthly debt payments to them. They will view you as a potential borrower and consider issuing you a loan.
A high DTI ratio probably means you have limited money to spend or don’t have enough money left over after you have paid all your monthly dues. You’ll more likely run into trouble paying your monthly payments to them.
The Factors That Make Up a Debt-to-Income Ratio
The debt-to-income ratio is made up of two factors: the front-end ratio and the back-end ratio.
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Front-End Ratio - This is also called the housing ratio. This shows what percentage of your monthly income goes to your housing expenses. This ratio includes your monthly mortgage payment, property taxes, homeowners insurance, and homeowners association dues.
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Back-End Ratio - This ratio is all about your other debt types—your other monthly debt obligations. This includes credit card or car loans, ongoing student loans, child support or alimony, or any other monthly debt that shows up in your credit report.
What Is an Ideal Debt-to-Income Ratio?
Lenders prefer a front-end ratio of no more than 28%, and a back-end ratio of 36% or lower including all expenses.
Although in reality, lenders would also take into consideration your credit score, savings, assets, and downpayment when assessing your situation. They would then choose to accept higher ratios depending on your financial standing.
A good rule to remember is:
- The lower the DTI ratio, the better the chances that you will be approved (or considered) for a credit or loan application.
- The lower your DTI ratio, the less likely lenders are to view you as a risky borrower.
Is There a Way to Lower My Debt-to-Income Ratio?
There are a few ways you can lower your DTI ratio. Some of the ways include reducing your monthly debt or finding new ways to increase your monthly gross income.
We’ll list down a few of these below.
- Track Your Spending - Here’s something you can control and do right away: create a budget plan and take the time to sit down and track all of your spending. Make a list of the unnecessary things you can do away with and put this money towards paying your mandatory debts instead. Jot down all your expenses—even those few measly dollars. Those measly dollars could accumulate to much more if tracked properly.
- Map Out a Plan - This is where paying your ongoing debts comes in. You can actually handle this one of two ways: by paying debts with the highest interest rate first, moving on to the second highest, and so on; or by taking care of the smaller credits first and clearing them all up before moving onto the big guns. There is no such thing as a “better” way of handling your debt. The important thing is to firmly stick to your strategy until it’s all cleared up.
- Find Another Source of Income - Are you an excellent writer? Do you have an eye for graphic design? Perhaps you can knit really well and think your pieces can be sold? In the digital age, a lot of money can be made online. Maybe you can start a side gig as a freelance writer or graphic designer and book jobs online. Set up an Instagram account or a Shopify store and use it as a platform to sell your knitted pieces.
- Manage Your Debt and Don’t Take On More - Look at ways you can lower your rates. Call your credit card company and see if they will accommodate you should you ask for lower interest rates. Chances are they probably will if you regularly pay your bills on time and your account is in good standing. You can also transfer balances from your higher-interest rate cards to a lower interest rate card to further decrease your monthly payments. Moreover, avoid making huge purchases using your credit card or taking on new loans for major purchases. Taking on new loans will just drive up your DTI ratio even more. Work on paying off your existing debts first before you decide to take on a new one.
Does My DTI Ratio Affect My Credit Score?
Your DTI ratio has little bearing on your actual credit score. But it’s important to remember that your credit utilization ratio accounts for 30% of your credit score—and if you have a high DTI ratio, it’s most likely that you have a high credit utilization ratio.
Credit utilization ratio is the outstanding balance on your credit accounts versus your maximum credit limit.
To give you a better example:
Say, your credit limit is $3,000 and you have a balance of $1,700. This would give you a 57% credit utilization ratio. You want to keep this number below 30% when you’re applying for a loan.
It’s important to lower this number because not only will you be paying down more debt, but this will also boost your credit score and lower your DTI ratio. Getting a secured credit card is an alternative way of building your credit score.
Calculate Your Debt-to-Income Ratio in 3 Easy Steps
This percentage is calculated by dividing your monthly debt payments by your monthly gross income.
- Add up all of your monthly debts. Monthly debts include: rent or mortgage payments, student loans, personal loans, auto loans, credit card payments, child support, alimony, etc.—basically anything that you’re required to pay on a monthly basis. Write this number down.
- Figure out your monthly gross income and write it down as well.
- Divide the sum of your monthly debts to your monthly gross income. For example, if you have monthly debts amounting to $3,500 and your monthly gross income is $7,200, the quotient is 0.4861. Convert the final figure to a percentage and round the number up if necessary. In the example, 49% is your final debt-to-income ratio.
Keep in mind that other monthly recurring bills such as utilities (water and electricity), gas money, groceries, insurance premiums, healthcare expenses, etc. are not part of this calculation.
And just because you qualify for a loan doesn’t mean you can actually afford the monthly payment that goes with it, as you have to take into account the amount of money that goes into these expenses when considering your entire budget.
Final Thoughts
Now that you understand what the debt-to-income ratio is and how it affects your financial standing, it’s important to be mindful of your spending habits and your debts, especially if you’re considering applying for a credit card or loan sometime in the future.
121 Financial Credit Union has been in the business for over 85 years, serving the people of Jacksonville, Florida. We are extremely dedicated to delivering highly personalized financial services that benefit our members and our community.
We’ll be more than happy to go over your numbers and give you the best advice on what your next best steps are regarding your current situation.