Your debt-to-income ratio (DTI) is an important data point used by lenders to evaluate how financially comfortable you would be taking on new debt. Its meaning is exactly what it sounds like: it compares your monthly debt payments to your monthly income. When you apply for a new loan, your DTI helps lenders measure how easily you could take on another monthly payment.
Imagine you were applying for a mortgage that came with a $1,500 payment each month. Lenders would use your DTI to make sure that after making all your existing debt payments, you could sufficiently afford the new $1,500 payment with your current monthly income.
Lenders use DTIs along with other aspects of your financial profile—like your credit history—to evaluate whether to give you a new loan. But before understanding why a DTI is important, it is crucial to know what a DTI calculation says about your finances.
How Do I Calculate My Debt-to-Income Ratio?
Your DTI is a simple calculation that compares your monthly debt obligations with your gross monthly income. To calculate your DTI, figure out how much you pay each month toward debt payments and divide that figure by your total gross monthly income.
For example, if each month you pay $1,000 for your mortgage, $400 for your student loan payment, $100 for credit card bills, and $500 for other miscellaneous debt payments, your total monthly debt obligation is $2,000—or the sum of all your payments. Then imagine your annual salary before tax is $60,000. Divide $60,000 by 12 to find your gross monthly income—in this case, $5,000.
Finally, divide your total monthly debt obligation ($2,000) by your gross monthly income ($5,000) and then multiply the resulting figure by 100 to convert it to a percentage. The final number you end up with is your DTI. In the example above, the DTI is 40%. In this situation, the DTI shows potential lenders that 40% of your gross monthly income is going toward debt payments each month, and 60% is left over for other monthly costs.
Why Does My Debt-to-Income Ratio Matter?
Once lenders see how much of your income is going toward debt payments each month, they can then establish how much you will have left over for other spending. Using this information, other data points like your credit score, as well as past experience, lenders can establish if they should give you a loan and for how much.
According to Bank of America, lenders use their knowledge of DTIs to predict when a customer might have financial difficulty making payments. They also use DTIs to determine lending amounts.
Depending on the institution, size, and type of loan, DTI ranges often vary, with some lenders accepting ratios of up to 50% and others capping DTI limits at 36%. In some cases, people with higher credit scores or substantial amounts of verifiable cash can still get approved for a loan despite having a high DTI.
Again, your DTI is only one of several aspects of your financial profile that lenders take into account when considering you for a new loan. Taking into account how lenders think about DTIs, it is important for borrowers to calculate and think about their ratio when they think about applying for loans.
If after calculating your DTI you find that you are spending more than 50% of your monthly income on debt payments, depending on the type of loan you want to apply for, you may have more success with lenders, and potentially get better terms for the loan, if you work to lower your ratio.
How Can I Improve My Debt-to-Income Ratio?
Improving your DTI is just one way to help make yourself more competitive for the specific loan that you want. Although your DTI is only one of several factors considered by lenders when you apply for a loan, the lower your ratio, the better off you are.
There are really on two simple steps that help improve your ratio:
- Increase your monthly income
- Decrease your monthly debt burden
To increase your monthly income, think about picking up a second job or asking your employer for a raise. In order to decrease your overall debt, think about your budget and see if there are any funds that can be redirected to pay your debt down.
By doing one or both of these things, you can decrease your ratio and better position yourself for the certain loans that you want.