Are you looking for a credit card or a loan? If the answer is yes, then you’ll need to know what your debt-to-income ratio is.
In order to assess your creditworthiness, financial institutions use debt-to-income ratios. Lenders want to be sure you make enough money to pay off all your debts before they extend you credit or give you a loan.
Maintaining a low ratio will make you a better candidate for both revolving and non-revolving credit, such as loans.
Would you like to know what debt-to-income ratio is and why you should monitor and manage it for better financial management? Well, keep reading to find out more.
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What is Debt-to-Income Ratio?
In short, a debt-to-income ratio (DTI) tells lenders how much money you spend on paying off debts compared to the money coming into your household. More specifically, it’s a key financial metric that tells lenders how much of a borrower’s gross income is spent on debt repayment. Generally, gross monthly income refers to your earnings before taxes and deductions.
You may encounter two types of DTI:
Front-end DTI. This is just your housing costs and how they relate to your gross income. In case you’re a renter, it includes your rent. For homeowners, it may include mortgage insurance, homeowners insurance, and property taxes.
Back-end DTI. This includes all your monthly payments for personal loans, student loans, and credit cards.
Typically, mortgage lenders will use both back-end and front-end DTI. If your DTI is higher than a low-DTI borrower, you pose a greater risk to a lender since you may find it more difficult to keep up with your payments.
Lenders may charge higher interest rates if your DTI is relatively high, as a result of the additional risk they are taking on. A high DTI may even lead to your application being denied.
How to Calculate Debt-to-Income Ratio
DTI is calculated by adding all your monthly debts together, then dividing them by your monthly gross income. To illustrate, let’s look at some numbers.
Add up your minimum monthly payments.
You only need to include recurring, regular payments in your DTI calculation.
Don’t use your account balance or what you usually pay, but your minimum payments. Using the example of a $10,000 student loan with $200 minimum payments, your DTI should only include the $200 minimum payment.
Costs associated with entertainment, food, and clothing
You can calculate your DTI by following this example. Let’s say you have the following monthly expenses:
Rent: $700
Student loan minimum payment: $150
Credit card minimum payment: $100
Auto loan minimum payment: $200
In this case, you’d add $700, $150, $100, and $200 for a total of $1,150 in minimum monthly payments.
Divide your monthly payments by your gross monthly income.
Generally, gross monthly income refers to your monthly pre-tax income. Your calculation may require you to include the income of anyone else who will be on the loan. When applying with someone else, you should take their income and debts into account. By dividing the total of your minimum monthly payments by the total of your gross monthly income, you can calculate the total gross monthly income for everyone on the loan.
Convert the result to a percentage.
A decimal value will result from the quotient. If you want to see your DTI percentage, multiply it by 100.
Let’s say your household’s gross monthly income is $3,500. Divide $1,150 by $3,500 to get .32, then multiply that by 100 to get 32. This means your DTI is 32%.
When do you include your spouse’s debt?
Your spouse’s debt may or may not be included in your mortgage application depending on whether you will be applying jointly or individually. In certain states, community property rules establish that marriage debts must be repaid equally by both spouses. The DTI ratio cannot exclude a spouse’s debt in those states.
The states where community property rules apply are:
Arizona
California
Idaho
Louisiana
Nevada
New Mexico
Texas
Washington
Wisconsin
Other than in Alaska, where couples can opt out of community property rules, common-law rules apply. There’s no law that says couples have to share their debts equally. In other words, they can apply for a loan as individuals, and the lender won’t look at the spouse’s income or debt.
When applied together, a lower, stronger DTI ratio is preferable in common-law states. The more income you have, the bigger the loan you can get.
Nevertheless, if a couple’s combined credit score and debt-to-income ratio severely affect their eligibility for a good mortgage loan, it’s best to apply separately.
What do lenders consider a good debt-to-income ratio?
It’s generally a good idea to keep your debt-to-income ratio under 43%. This is a good target since it’s the maximum debt-to-income ratio for a Qualified Mortgage, which is a stable, borrower-friendly loan.
36% or less
When your DTI is 36% or less, you probably have a healthy amount of income each month to invest or save. You’ll be able to afford monthly payments for a new loan or line of credit from most lenders.
36% to 41%
Debt-to-income ratios between 36% and 41% suggest manageable debt levels. If you’re applying for a bigger loan or a loan with strict lenders, however, they may want you to lower your DTI ratio before they approve you.
42% to 49%
If your DTI is between 42% and 49%, you’re approaching unmanageable debt levels. It might be hard for lenders to believe you can make payments on another line of credit.
50% or more
When your DTI is 50% and higher, it could be construed that you have difficulty meeting all your debt obligations on a regular basis. To get a loan or line of credit, lenders might need to see you reduce your debt or increase your income.
How Does Your DTI Ratio Affect You?
You might not be able to get a mortgage if you have a high debt-to-income ratio. What’s more, you’ve got a better chance of qualifying for a home loan if you have a lower DTI.
You can also get lower mortgage rates by improving your debt-to-income ratio, which determines whether you’re eligible for the type of loan you want.
In the case of mortgage loans, refinancing mortgages, and home equity loans, lenders factor DTI into the equation.
But, that’s not all. Having a debt-to-income ratio higher than 43% can have adverse effects on your financial life in multiple ways, none of which are good:
Your budget is less flexible. When you spend most of your income on debt repayment, there is less left over for saving, investing, or spending.
Credit terms are less favorable when you borrow or seek credit. With a high debt-to-income ratio, you’re seen as a riskier borrower. It is possible that lenders will assign higher interest rates to loans or credit to risky borrowers, impose steeper penalties for missed or late payments, and impose stricter conditions for them.
What is the debt-to-income ratio to qualify for a mortgage?
Mortgage lenders look at debt-to-income ratios when approving mortgage loan applications. Your DTI is calculated when you purchase your first home based on estimated payments, taxes, and fees. Lenders may accept higher ratios based on your credit score, savings, and down payment.
There are guidelines in place that can serve as a guide for lenders. But the limits can vary depending on the type of loan and the applicant’s overall financial profile.
Due to a 2007 increase in Fannie Mae’s DTI limit, most lenders will not be able to exceed 50%.
For qualified mortgage loans, prospective borrowers should aim for a DTI of at least 43%. To prevent high-risk loans between lenders and borrowers, these loans follow federal guidelines.
Taking a look at some examples of lenders in real life will give us an idea of how this works:
DTI limits are set at 50% for most Quicken Loans loans, except for VA loans, where they’re up to 60%. If you’re interested in this type of mortgage, check out the best VA loans.
As part of its recommendations, Veterans United recommends a debt-to-income ratio of 41% or lower, including mortgage debt in the calculation. There is no limit to the DTI ratio. But borrowers with a DTI of 41% or higher must have a residual income that exceeds Veterans United’s requirements by at least 20%.
A DTI ratio as high as 47% is acceptable to Better Mortgage
There is a 50% limit on Rocket Mortgage
There are also limits on federally guaranteed loans:
For USDA loans, the front-end ratio is 29% and the back-end ratio is 41%. You should let lenders approve candidates with higher percentages if they have to compensate factors, like supplemental income, generous savings, or strong credit history, that prove their ability to repay.
The FHA loan limit is up to 50%, but other factors play a big role as well. With a low credit score, your DTI ratio can’t exceed 45% to qualify, while a higher score usually gives you more options.
Ideally, you want to select a mortgage lender that offers the best rates and terms.
How much debt-to-income should you have when refinancing?
When you refinance, lenders will also look at your DTI ratio. If you have a high DTI, refinancing your home loan will be harder. To see if refinancing your mortgage is right for you, use a refinance calculator.
A DTI of 40% or less is recommended for cash-out refinances by Chase.
According to Rocket Mortgage, most lenders prefer consumers who have a DTI of 50% or less when refinancing their mortgages.
To qualify for a home equity loan, what is the debt-to-income ratio?
DTI also affects how much you can access from your home equity. For home equity loans and lines of credit, lenders will take your DTI into account along with loan-to-value and combined loan-to-value ratios.
In comparison with mortgages, home equity loans have more restrictive requirements. To qualify, borrowers must have a DTI of less than 43%, and some lenders may even require a DTI of less than 36%. Examples include:
A DTI of 43% or lower is recommended by Quicken Loans for home equity loans because of the stricter requirements.
DTI ratios are not capped for Veterans or military members who are members of Veterans United. However, those with a DTI above 41% may encounter additional financial scrutiny.
Anyone with a DTI higher than 43% will not be eligible for a Rocket Mortgage home equity loan.
How much does your debt-to-income ratio affect your credit score?
Credit scores or credit reports are never affected directly by your DTI. While credit-reporting agencies can know your income, they do not consider it when calculating your credit score. When you apply for a home loan, your creditworthiness is still considered.
Nevertheless, borrowers with high DTI ratios may also have high credit utilization ratios, which account for 30% of your credit rating. Due to the fact that you are paying down more debt as you lower your credit utilization ratio, your credit score will increase and your DTI ratio will decrease.
How To Lower Your DTI Ratio
Lowering your DTI can be accomplished in a number of ways. As well as reducing overall debt, you will also reduce monthly payments.
Establish a monthly budget. You’ll gain a better understanding of your spending patterns and see where you can cut back. The process of budgeting can be streamlined with secure and free apps if paper and pen aren’t your thing.
Pay off your smallest debts. The fastest way to reduce your debt-to-income ratio? Eliminate monthly payments. Whenever you can pay off your smallest debt first. That’ll drop your DTI right away.
Debt with a high ‘bill-to-balance’ ratio is a good target. In this way, you can reduce your DTI for the least amount of money possible. For example, a mortgage application should also be filed after you have repaid your auto loan.
Pay attention to your loan payments. Don’t wait until the last minute to pay off your loans. If you wish to lower your monthly payments, you can extend the term of your loans.
Refinance or consolidate your debt. A balance transfer can lower your interest rate on your loans through debt consolidation or refinancing.
See if you can get your federal loans forgiven. If you meet certain conditions, you may be able to get your student loans forgiven by the federal government
Boost your income. Negotiate a higher salary or add a side income, such as renting out a spare room or delivering food.
Apply with a co-borrower with a lower DTI. It’s possible to increase your approval rates if you combine their income with their DTI, but beware of the credit score they have. If you plan on making a large purchase with credit, wait until the application process is complete before making it.
Monitor Your DTI and Your Credit For Better Access to Credit
You should keep an eye on your DTI and your credit score even if you aren’t planning on applying for credit anytime soon. When you pay off a loan or credit card or take on new credit, calculate your DTI whenever you pay off a debt.
To check your credit score, you can take advantage of Experian’s free credit monitoring service, which gives you access to your Experian credit report and FICO® score. You’ll also be notified when your credit report changes in real-time, so you’ll be able to spot any potential problems early on.
FAQs About Debt-to-Income Ratio
1. What is the importance of debt-to-income?
Debt-to-income ratios are used by lenders to assess the ability of borrowers to manage their monthly payments and repay their loans.
2. Is all debt treated the same in my debt-to-income ratio?
In the end, your total recurring debt can improve or lower your mortgage qualification chances depending on your debt-to-income ratio. There is no difference in the ratio based on the type of debt. If you have a lot of debt, your DTI will be higher and it’ll be harder to qualify.
3. How do you calculate your debt-to-income ratio?
Adding up your monthly debt obligations and dividing by your gross monthly income will give you your debt-to-income ratio. Our calculator can help you calculate your debt-to-income ratio without manual calculations.
4. What payments should not be included in debt-to-income ratio?
It is not necessary to include the following payments:
Utility bills, such as water, garbage, electricity, or gas
Cable and cell phone bills
The cost of car insurance
Health insurance costs
Expenses related to groceries, food, or entertainment
In case you’re not sure what items are considered when calculating your debt-to-income ratio, ask your lender.
5. What is the fastest way to improve my DTI?
By repaying your debt immediately, you can improve your DTI since it is based on the total amount of debt you owe. By paying it down aggressively, you’ll improve your ratio and look more attractive to lenders on your mortgage application.
Alternatively, you can work a second job or side gig to earn more money.
6. When it comes to debt-to-income ratios, what is a good number?
In general, a good DTI ratio should range from 36% to 43% – the lower the number, the better. DTI ratios above 43% are considered indicators of financial stress. Although it doesn’t disqualify the borrower, it makes getting a good loan offer harder.
7. What sources of income are considered?
The following sources of income are considered by lenders:
8. Should I apply for a home loan with a high DTI?
If your debt-to-income ratio is high, lenders may be less willing to lend you a mortgage loan or may charge you a higher interest rate, causing you to pay more. Despite being able to obtain a mortgage loan with a high DTI, it’s best to lower the ratio as much as possible to get a lower interest rate.
9. To buy a house, what should your DTI be?
Mortgage lenders recommend paying off debt with roughly a third of your income. Furthermore, you should not spend more than 28% of that debt on mortgage repayments. For mortgage approval, a DTI of 36% or lower is recommended. For mortgage approval, a DTI of 36% or lower is recommended.
10. What is the difference between debt-to-income ratio and credit utilization rate?
Your financial profile is taken into account in both calculations but in different ways.
The DTI ratio calculates how much money goes toward paying off your debt based on your income and monthly obligations. DTI ratios are used by lenders to evaluate borrowers, but they don’t affect your credit score.
The credit utilization rate is a key evaluating factor of your credit score. This calculation measures your credit usage by comparing your maximum credit limit to your outstanding balance. Unlike the DTI ratio, the credit utilization rate only considers revolving credit — credit cards, personal credit lines, and HELOCs. It doesn’t factor in installment debt or your monthly income.
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