How Important is Your Debt-to-Income Ratio?
When talking about credit and debt, we tend to focus mostly on our credit utilization. This number – calculating the amount of debt you are carrying compared to your overall credit limits – is an important factor in your credit score and your perceived creditworthiness. But it’s not the only percentage to consider; there’s also your debt-to-income ratio.
Just how important is the debt-to-income ratio, though, and when does it matter? Do lenders really take it into consideration, and can a high ratio impact your financial plans?
Let’s take a look at when your debt-to-income ratio matters and what you can do about it.
What DTI is
As the name implies, your debt-to-income (DTI) ratio is a comparison of how much of your annual income is eaten up by payments toward existing debt. It’s different than your credit utilization ratio – which compares how much of your credit limit you’re actually using – and may actually give a better idea of where you stand financially. At the very least, it gives potential lenders a good view of how much disposable income you have each month once your mandatory debt payments are made.
Every balance you carry has a minimum payment due each month, from your mortgage loan to your credit card account and everything in between. Of course, you can choose to pay more than this amount, but that’s the bare minimum that you have to pay to keep your account in good standing.
These are the numbers that potential lenders will use when gauging your DTI ratio.
How to Calculate Your DTI
You won’t find your DTI listed when you pull your annual credit reports. You probably won’t see it shown anywhere you’re tracking your credit, in fact. Instead, you’ll almost always need to calculate it yourself.
Luckily, doing so is very easy. Simply take the amount that you are required to pay toward your debt each month and divide it by your take-home, available income. This gives you your debt-to-income ratio.
Let’s say that you bring home $5,000 a month in income. You have a mortgage, an auto loan, and two credit card balances; between them, your minimum payments due add up to $1,950 each month. This means that your DTI is 38%.
Of course, this ratio doesn’t take into account your other monthly expenses or spending. It does, however, give lenders an idea of the absolute maximum percentage of income that you could have at your disposal… and how much is already spoken for by your debt.
The Ideal DTI
If you’re looking at taking out a new mortgage, for example, your debt-to-income ratio will absolutely be taken into account. Lenders want to know that you aren’t already overextended just trying to pay off existing debt; if your DTI is too high, you’ll likely be denied for additional loans.
According to the Consumer Financial Protection Bureau, the ideal DTI is 43% or below. Anything between 44% and 49% is toeing the line, and 50% is the threshold for a “high” debt-to-income ratio. Once you hit 50%, you will likely have trouble getting approved for new loans, especially something as large as a home mortgage.
How to Improve Your DTI
There are a few ways that you can reduce your debt-to-income ratio, some of which are easier than others.
The first, and most obvious, is to pay down your debt. Installment accounts, like a mortgage or auto loan, won’t reduce the monthly payment in relation to the total debt owed; those monthly payments stay constant. Instead, you can focus your efforts on revolving accounts like credit cards.
You should also aim for the revolving account with the highest monthly payment first. As the balance goes down, so will the minimum payment due each month, lowering your DTI along with it.
You can focus on the other side of the equation, too: your income. By asking for a raise, getting a new job, or even just bringing in some extra cash with a side hustle, you can boost your salary and improve your debt-to-income ratio at the same time.
You could also transfer debt to a 0% APR credit card. Since you won’t be paying interest on the balance for a promotional period of time, your minimum amount due (and the total amount paid out) will lower. This could help your DTI significantly.
While your debt-to-income ratio doesn’t impact your FICO score and isn’t even tracked on most credit monitoring sites, it’s still very important to your overall financial picture. It’s especially pertinent if you’re planning to, say, apply for a home mortgage in the near future. In that case, you’ll want to ensure that your DTI is no higher than 43%, if not significantly lower.