You may have heard that you need a good debt-to-income ratio, but that doesn’t mean you know exactly what is the debt-to-income ratio and how to calculate it. In a nutshell, your debt-to-income ratio (DTI) is what percentage of your monthly income that you use to pay your debt. Lenders use it to determine if you can afford to take on additional loans, and how risky you are to lend money to. With that, it is also used to determine what interest rate you get, if you are approved.
Debt-to-income ratio = Divide your monthly debt payments by your gross monthly income (pre-tax income).
What is the Debt-to-Income Ratio?
Your debt-to-income ratio (DTI) is the percentage of your gross income that you use to make your monthly debt payments. In other words, how much do you earn versus how much are you spending? Lenders consider DTI when assessing your creditworthiness as it tells them how much more debt you can afford to take on–or not.
Here are the two types of DTI ratios:
- Front-end DTI: This is your monthly housing costs and how they relate to your gross monthly income. For example, if you rent, your front-end DTI includes your monthly rent payment. But if you’re a homeowner, your front-end DTI may include your monthly mortgage payment as well as any other housing-related costs, such as homeowners insurance and property taxes.
- Back-end DTI: This includes all your monthly debt, such as any installment loan payments you may have (e.g., personal loan, student loan, auto loan) and credit card payments.
Lenders typically use back-end DTI, though mortgage lenders often use both front-end and back-end DTI to get a broader picture of your income versus expenses. In general, the higher your ratio is, the higher the risk you are in the eyes of a lender. This is because as your DTI ratio goes up, the amount of money you have available to make additional payments goes down.
Why Does DTI Matter?
Your debt-to-income ratio matters because lenders use it to help them decide whether or not they will approve your loan application. Oh top of that, your DTI may also impact the interest rate you get. For example, if your DTI is on the higher side, you may still get approved, but you will likely get approved with a worse interest rate than if your DTI was on the lower side. Again, this is because a high DTI makes you appear risky and so lenders offset the risk with a higher interest rate.
What Is a Good Debt-to-Income Ratio?
As a general rule of thumb, a good DTI ratio is a low as close to zero as possible. However, generally, a DTI of 43% or less is considered “good.” In fact, this is widely revered as the maximum DTI to qualify for a mortgage.
DTI ratio of 36% or less
If your DTI ratio is 36% or less, it means you have a good amount of monthly income that you can use for savings or investing purposes. Lenders will also consider you as someone who can afford to pay their monthly payments for any new loan or credit line.
DTI ratio of 36% to 41%
Based on your income, your debt-to-income ratio (DTI) falls between 36% and 41%, which means that your debt is at a manageable level. However, if you are applying for larger loans or loans from strict lenders, they may require you to reduce your DTI ratio by paying off some of your debt before they approve your application.
DTI ratio of 42% to 49%
If your DTIs fall between 42% and 49%, it means that your debt levels compared to your income are becoming hard to manage. This may lead lenders to doubt your ability to make payments for any additional credit line.
DTI ratio of 50% or more
If your DTI level is 50% or more, it may imply that you have difficulty in consistently paying off your debts on time. To be eligible for a loan or credit, lenders may require you to either decrease your debt or increase your income.
How to Calculate Your Debt-to-Income Ratio in 3 Steps
Calculating your debt-to-income ratio, or DTI, is a simple three-step process. First, add up all of your gross (pre-tax) monthly income, including wages, alimony, child support, etc… Then add up your total monthly debt payments (such as credit card payments, car loans, student loans and rent/mortgage payments). Third, divide your total monthly debt by your monthly gross income.
Here’s how to calculate your debt-to-income ratio in three steps:
1. Add up your monthly debt payments
To start, add up all of your monthly debt payments. This includes housing (i.e., rent or mortgage payments), monthly payments on any installment loans you may have (i.e., student loans, auto loan or lease, etc…) and your monthly minimum credit card payments.
For example, let’s say you have the following monthly payments:
- Rent: $1900
- Auto loan: $420
- Student loan: $293
- Minimum payment on credit card #1: $85
- Minimum payment on credit card #2: $60
After adding all of these monthly payments up, your total monthly debt payments would be $2,758.
2. Identify your gross monthly income
This is your monthly income before taxes. If you’re paid weekly, be sure to multiply your weekly paychecks by four. If you’re paid bi-weekly, multiply your bi-weekly paychecks by two.
For example, let’s say your bi-weekly pay is $2,400. You would multiply that number by two to get your gross monthly income of $4,800.
3. Divide your total monthly debt by your monthly gross income
To calculate your DTI, take your total monthly debt and divide that by your monthly gross income.
For example, if your total monthly debt is $2,758 and your total monthly income is $4,800, you would divide $2,758 by $4,800 to get a DTI ratio of .57 or 57%.
How to Improve Your Debt-to-Income Ratio
There are two main ways to lower your DTI ratio. You need to either reduce your debt or increase your income. Of course, there are a number of ways to do either of these things, such as asking for a raise or taking on a side job, making extra payments to your principal to reduce your debt, decreasing your day-to-day spending as means of saving more money which you can put towards paying down your debt and avoid racking up further debt by stashing away those credit cards.
Here are a few top ways to improve your debt-to-income ratio:
- Ask for a raise at work
- Get a part-time job on the side
- Pay down your credit card balances
- Decrease your day-to-day spending so you can save more and make larger payments to your principal
- Stop using your credit card and accumulating debt
Again, anything you can do that helps to either increase your income or decrease your debt will effectively improve your DTI ratio. It’s important to find ways that work for you.
Bottom Line: Debt-to-Income Ratio
Debt-to-income (DTI) ratio is an important tool for assessing the financial health of individuals and households. It’s helpful to understand DTI and know your DTI ratio when applying for loans. It’s also wise to work on improving your DTI ratio in order to increase your creditworthiness and odds of getting approved for a loan–at a lower interest rate. Even outside of loans, it’s wide to know your DTI as it helps you get a pulse on whether you’re overextending yourself financially, which can help you reel it back and improve your financial well-being.
Frequently Asked Questions (FAQs)
How is the debt-to-income ratio different from the credit utilization ratio?
The debt-to-income (DTI) ratio is a measure of all monthly debt payments divided by gross monthly income. It is used by lenders to assess an individual’s ability to manage their finances and repay money that has been borrowed. The credit utilization ratio, on the other hand, is the amount of credit being used compared to the total available. This ratio measures how much of your available credit limit you are using at any given time. Learn more about the credit utilization ratio and how to calculate yours.
How can I improve my chances of getting approved for a loan or credit card?
The best way to improve your chances of getting approved for a loan or credit card is by reducing your debt-to-income ratio. You can do this by either lowering the amount of debt you have or increasing your income. You can also work on improving your credit score. Learn more about how to improve your credit score in under a month.
How can I get a copy of my credit report?
To get a copy of your credit report, visit annualcreditreport.com. You can also request a free copy of your credit report from each of the three major credit bureaus: Experian, Equifax and TransUnion.
- How to get your Experian credit report
- How to get your Equifax credit report
- How to get your TransUnion credit report
Does a soft pull affect my credit?
No, a soft pull does not affect your credit score. A soft pull is when lenders and creditors check your credit report to see if you meet their lending criteria. It’s typically done as part of the pre-approval process for a loan or credit card. Learn more about soft inquiries and hard inquiries.