Do you know what your debt-to-income ratio is?
Your bank does.
It’s how they decide to approve or reject you for a loan. DTI sounds complicated and can leave you with a pit in your stomach if you need fast cash, but it doesn’t have to be daunting.
Keep reading and you’ll understand how to calculate debt-to-income ratio in no time.
Understanding Your Debt-To-Income Ratio
Put simply, your debt-to-income ratio (DTI ratio) is a measure of your debt compared to your income. It describes your ability to manage debt and make payments on time.
This ratio gives an idea of how much of your income goes toward paying off debts.
Why Your Debt-To-Income Ratio Matters
Your DTI ratio is crucial when applying for credit. Lenders look at it to figure out how credit-worthy you are—and it’s a determining factor when it comes to securing a loan. A high DTI ratio makes it harder to get approved for credit and drives up interest rates when you apply.
A low ratio helps you qualify for better terms and cheaper repayment plans.
In addition, understanding your DTI ratio can help you make better financial decisions and avoid getting trapped in a vicious cycle of debt.
Factors Affecting Your Debt-To-Income Ratio
The two most obvious factors in your DTI ratio are simple: Your income, and your debts. However, reality can be more complicated. The types of debt and income you have are important.
In general, DTI ratios are calculated on a monthly basis because payments and earnings generally happen on a monthly schedule. Common monthly payments include:
- Car loans
- Student loans
- Mortgage payments
- Credit card payments
- Monthly subscriptions
- Alimony payments
Meanwhile, sources of monthly income aren’t limited to your salary. Other sources of income might include:
- Wages and salaries
- Overtime bonuses
- Investment income
- Rental income
- Other sources of passive income
Some types of debt, such as credit card debt, are considered more risky than others, such as a mortgage. Credit card debt carries high-interest rates and can quickly accumulate, making it harder to manage, so these kinds of debt can negatively impact your DTI ratio and your scoring by lenders.
How to Calculate Your Debt-To-Income Ratio
Calculating your DTI ratio isn’t difficult as long as you’re on top of your paperwork.
Start by adding up all your monthly debt payments, including credit card bills, car loans, student loans, and mortgage payments. For married people, it can be helpful to consult with your spouse if one of you is responsible for managing finances – though in general, everybody’s credit is rated individually.
Once you’ve calculated your monthly debt, divide that number by your monthly gross income. The result is your DTI ratio, which you can multiply by 100 to get a percentage score. Here’s a quick example.
If you pay $1,000 per month for your mortgage and another $500 for other debts, your total payments add up to $1,500 per month. With a gross monthly income of $4,500, your DTI ratio will look like this:
Total Monthly Debt Payments = $1,500
Total Monthly Income = $4,500
DTI Ratio = (1,500 / 4,500) = 0,33
Multiplied by 100, the DTI ratio in this instance would be 33%.
Understanding the Results
So, what does your debt-to-income ratio mean?
A lower value is always better. Generally, many lenders look for a ratio that is below 36%. Of that, no more than 28% should go towards mortgage repayments. If your debt-to-income ratio is within this range, lenders will generally view you as a low-risk borrower, and you are more likely to be approved for loans or credit.
If your DTI ratio is higher than 36%, you’ll quickly find that it becomes harder to secure credit. It shows that a lot of your income is already earmarked for paying off debts, leaving you with less disposable income to manage unexpected expenses or savings. Lenders may perceive you as a high-risk case and offer you less favorable loan terms or interest rates.
But it’s not always as cut and dry as that.
Different lenders may have varying requirements. Some lenders may be more lenient and may approve borrowers with higher ratios if they have other compensating factors such as a high credit score or a steady employment history.
Improving Your Debt-To-Income Ratio
If your DTI ratio is high, you need to improve it to improve your odds when applying for credit or filling out an online loan application.
The two sides of the coin are what you’d expect: lowering your debt and increasing your income. Of the two, it’s often easier to address your debt payments.
Lowering Your Debt
Less debt means more disposable income that you can put towards savings, investments, or settling other debts. The factors you need to look at are:
- Credit card debts
- Loan repayments
- Consolidating your debt
- Avoiding new debt
Firstly, you’ll want to tackle outstanding credit card debts. Those debts can be the biggest contributors to a high debt-to-income ratio. If you have multiple credit cards with balances, prioritize paying off the one with the highest interest rate. Then move on to the next and repeat until the balance is repaid in full.
If you have outstanding loans, consider making extra payments each month to pay them off faster. And if you’re saddled with multiple high-interest debts, consider consolidating them into a single loan.
Not only does this make it easier to keep an eye on your outstanding debt, but it often results in lower interest payments. That puts money back in your pocket.
Increasing Your Income
Another way to improve your DTI ratio is to increase your monthly income.
Negotiating a raise at work can be daunting—but taking a leap of faith can yield dividends if you think you’ve earned it. Taking on a part-time job is an alternative, and starting a side hustle in the gig economy can yield good results if you’re willing to put in the groundwork.
Increasing your income can not only help you pay off debt faster, but it can also improve your debt-to-income ratio and make it easier to get approved for loans or credit.
Manage Your Debts
It’s not hard to calculate your debt-to-income ratio—and knowing where you stand puts you in the best position to get approved for new credit.
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