A debt-to-income ratio (DTI) is a personal finance metric that compares the amount of debt you have to your overall income. Lenders, including mortgage originators, use it to measure your ability to manage the payments you make each month and repay the money you borrow.
Key points to remember
- Lenders look for low debt-to-income (DTI) numbers because they often believe that those borrowers with a low debt-to-income ratio are more likely to successfully manage monthly payments.
- The use of credit affects credit scores, but not debt ratios.
- Creating a budget, paying off debt, and developing a smart savings plan can all help fix a bad debt ratio over time.
Understanding the Debt to Income Ratio
A low debt-to-income ratio demonstrates a good balance between debt and income. In general, the lower the percentage, the better your chances of getting the loan or line of credit you want.
On the contrary, a high debt-to-income ratio signals that you may be in too much debt for the income you have available, and lenders take this as a signal that you may not be able to take on additional obligations.
Calculate debt to income ratio
To calculate your debt-to-income ratio, add up the total of your recurring monthly obligations (such as mortgages, student loans, car loans, child support, and credit card payments) and divide by your monthly income gross (the amount you earn each month before taxes and other deductions are taken).
What is considered a good debt-to-income ratio (DTI)?
DTI and getting a mortgage
When you apply for a mortgage, the lender considers your finances, including your credit history, your monthly gross income, and the amount of money you have available for a down payment. To determine how much you can afford to buy a home, the lender will look at your debt ratio.
Expressed as a percentage, a debt-to-income ratio is calculated by dividing the total recurring monthly debt by the monthly gross income.
Lenders prefer to see a debt-to-income ratio below 36%, with no more than 28% of that debt going towards servicing your mortgage. For example, suppose your gross income is $4,000 per month. The maximum monthly mortgage payment at 28% would be $1,120 ($4,000 x 0.28 = $1,120).
Your lender will also look at your total debts, which should not exceed 36%, or in this case, $1,440 ($4,000 x 0.36 = $1,440). In most cases, 43% is the highest ratio a borrower can have while getting a qualifying mortgage. Beyond that, the lender will probably refuse the loan request because your monthly housing expenses and various debts are too high in relation to your income.
DTI and credit score
Your debt ratio does not directly affect your credit score. Indeed, the credit organizations do not know how much money you earn, so they are not able to do the calculation.
Credit agencies, however, look at your credit utilization rate or debt-to-equity ratio, which compares all of your credit card account balances to the total amount of credit (i.e. the sum of all credit limits on your cards) you have available.
For example, if you have credit card balances totaling $4,000 with a credit limit of $10,000, your debt ratio would be 40% ($4,000 / $10,000 = 0.40 or 40% ). In general, the more a person owes relative to their credit limit, i.e. how far the cards are maxed out, the lower the credit score will be.
Reduction in debt-to-income ratio (DTI)
Basically, there are two ways to reduce your debt ratio:
- Reduce your monthly recurring debt
- Increase your gross monthly income
Of course, you can also use a combination of the two. Let’s go back to our example of the debt-to-income ratio at 33%, based on a total recurring monthly debt of $2,000 and a gross monthly income of $6,000. If the total recurring monthly debt were reduced to $1,500, the debt-to-income ratio would correspondingly decrease to 25% ($1,500 / $6,000 = 0.25 or 25%).
Similarly, if debt remains the same as in the first example but we increase income to $8,000, the debt-to-income ratio decreases again ($2,000 / $8,000 = 0.25 or 25%).
Of course, reducing debt is easier said than done. It can help to make a conscious effort to avoid taking on more debt by considering needs versus wants when spending. Needs are the things you must have to survive: food, shelter, clothing, health care, and transportation. Wants, on the other hand, are things you wish you had, but don’t need to survive.