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Your debt-to-income ratio (DTI) is an important measurement for not only determining whether you qualify for a new loan or credit card, but also how you're doing financially.
To calculate your debt-to-income ratio, simply divide your total monthly debt payments by your gross monthly income. Your DTI isn't the only factor lenders consider, and the right ratio can depend on the type of loan you're applying for.
But knowing your DTI and being able to calculate it is a valuable step in understanding how to manage your debt when thinking about applying for a new loan.
What Is Debt-to-Income Ratio?
Your debt-to-income ratio, often called DTI, is how much of your gross income goes toward debt payments every month. From a lender's perspective, it shows how much more debt you can reasonably take on given your current income and debt situation.
There are two types of DTI that you may run into: front-end and back-end. Front-end DTI represents only your monthly housing costs and how it relates to your gross monthly income, while back-end DTI includes all your monthly debt obligations. Most lenders use back-end DTI only, but mortgage lenders typically use both.
The higher your ratio is, the more risk you pose to a lender because it may be more difficult for you to keep up with your payments compared with a low-DTI borrower.
If your DTI is relatively high, a lender may charge a higher interest rate to compensate for their added risk. You may even be denied because your DTI is too high.
How Is Debt-to-Income Ratio Calculated?
To calculate your debt-to-income ratio, establish what your total monthly debt obligation is and divide that figure by your gross monthly income.
For example, if each month you pay $1,000 for your mortgage payment, $250 for your auto loan, $100 for your student loan and $200 for various other debt, your total monthly debt obligation—the sum of all your monthly payments—is $1,550.
To calculate your gross monthly income, take your salary before taxes and other deductions, and divide it by 12. So if your annual salary is $60,000, your gross monthly income would be $5,000.
Now take your total monthly debt obligations ($1,550) and divide them by your gross monthly salary ($5,000). Then convert the resulting number (0.31) into a percentage by multiplying it by 100; in this case, 31% is your DTI.
If you're buying a house and applying for a mortgage loan, the lender will use the calculations above to calculate your back-end DTI, but will also consider your front-end DTI. To calculate that, simply divide the mortgage payment ($1,000) by your gross monthly income ($5,000), and you'll get 0.20, or 20%.
How Does Debt-to-Income Ratio Affect Credit?
Your DTI doesn't directly affect your credit scores because credit scoring models ignore income information. However, amount owed plays a factor in your credit utilization rate, which is the second-most influential factor in your FICO® Score☉ .
Your credit utilization rate is your credit card balances divided by total credit limits. It indicates how much of your available credit you're using. Credit experts recommend keeping your utilization rate below 30%, and the lower it is, the better. For top credit scores, keep your utilization under 7%.
But your DTI also includes how much you owe on other types of credit accounts, including installment loans and other revolving credit lines. The more debt you're carrying on credit cards and other loans, and the higher your utilization rate, the more negatively it can impact your credit scores.
What Is a Good Debt-to-Income Ratio?
Your DTI helps lenders quickly see how your debt matches up to your income, giving them an idea of your ability to pay any new debt every month. Generally, the lower your DTI, the better, because this shows lenders you have the extra income after your current debt obligations to take on new loan payments.
The ideal DTI, however, depends on the type of loan you're applying for and the lender. For example, when applying for a personal loan, a higher DTI may be acceptable; but when applying for a mortgage, the lender may have stricter standards.
With mortgage loans, for instance, lenders may look for a front-end DTI of 28% or lower—the maximum for an FHA loan is 31%—and a back-end ratio less than 43% (though sometimes less than 36%). Conventional-loan guidelines by Fannie Mae and Freddie Mac allow for back-end DTIs as high as 50% in some circumstances.
While other loan types are available to those with a DTI over 50%, a ratio that high can restrict your ability to borrow. Each lender has its own criteria for determining eligibility, and a high DTI can put you at risk of getting denied or getting approved but with a high interest rate.
While it's important to work to reduce your DTI, remember that it's not the only factor lenders evaluate. They'll also look at your credit reports and credit scores, your employment situation and other important factors. As you consider how to improve your chances of getting approved for a loan with favorable terms, be sure to look at the whole picture and how you can represent as low of a risk as possible to future lenders.