How Debt-to-Income Ratio Is Calculated

How Debt-to-Income Ratio Is Calculated

Debt-to-income ratio (DTI) is one of those financial terms that probably sounds vaguely familiar to you. You know you’ve heard it somewhere before, but you can’t quite remember what it is – or why you should care. The truth is, unless you have applied for a loan recently, you probably haven’t given it much thought at all.

How Debt-to-Income Ratio Is Calculated

But if you have recently applied for a loan, or if you plan to soon apply for credit of any kind, your DTI is something you are going to need to know. In fact, creditors view this number as the most critical factor in determining whether or not you qualify for a loan. It is even more important than your credit history or even your FICO score. If you are unsure what your personal ratio is, it is time to find out.

What Is Debt-to-Income Ratio and How to Calculate It

In its simplest terms, DTI is the amount of debt you have compared to your income. This is calculated by taking the total amount you spend per month on debt repayment and dividing it by your gross monthly income. The result is the primary number that lenders use to determine your credit-worthiness – in other words, how likely you are to be able to pay them back.

Let’s take a look at DTI in real numbers, using a quick and easy formula. Say your total gross monthly income is $6,000. If your mortgage is $1,500 per month, and you also have a $400 car payment, a total of $300 in credit card payments, and $200 in student loans, your total monthly debt payment equals $2,400. If you divide the debt payment ($2,400) by your gross income ($6,000), you will determine that your DTI is 40%.

Two Frequently Asked Questions When Calculating DTI

  1. What is total gross income?

Everything you make, before taxes or any other deductions, is your gross. This includes salary, tips, social security and retirement income, child support or alimony, earnings from real estate and investments, and any other type of verifiable income, as listed on your tax return.

  1. How do you determine total monthly debt amount?

Some payments, such as auto loans, are static and remain the same throughout the life of the loan. Payments on other debts, such as credit cards, can vary month to month, and may or may not have a definite payoff date. For the purposes of calculating your DTI, it is fine to use the minimum required monthly payment amounts for all debts, even credit cards. You do not need to include utility payments, car or health insurance premiums, school tuition or childcare, or any other expenses outside of those directly made toward debt repayment. Those are considered “lifestyle expenses” and are not counted when calculating your debt to income ratio. 

What Is a Healthy Ratio

Your DTI is a good way to check the temperature of your overall financial health. So whether you are in the market for a new loan or not, it is a number you would be wise to know.

If your DTI is anything less than 35%, most financial experts would place you in the healthy category. You’re likely to be approved for an appropriate loan (provided you qualify). A DTI between 36% and 42% is considered more risky. Many lenders will often approve your loan at this level (again, provided you qualify), but they will charge you a higher interest rate.

Every loan application is different, and every financial situation is unique, but 43% is widely considered to be the DTI ceiling for lenders. If yours is above that line, your chances of getting approved for a loan are much lower. This is even the case if you have a good credit score and make all of your payments on time. You don’t want to be surprised by a loan application denial, which is why it pays to know your DTI even before you apply for a loan.

There are exceptions to every rule, of course, and the exception to the 43% threshold is something called a debt consolidation loan. Debt consolidation loans are custom-made for people who, for one reason or another, find themselves debt-heavy beyond their means to remedy and need to refinance their debt. These lenders understand the borrower’s need for debt refinancing and are in business specifically to help them.

How to Improve Your Ratio

What should you do if you find yourself with a DTI above 43%? There are two straightforward ways to lower yours: either increase your income or lower your debt. Neither are simple or easy, but both of them are possible.

how to improve your DTI ratio

One way to increase your income is to ask for a raise at work. Another is to seek out freelance work such as lawn care or babysitting. Some people choose to temporarily get a second job, just until their financial situation has improved significantly. If you use the increased income to directly pay down your excess debt, you can accomplish both goals at the same time.

If you don’t realistically see a way to increase your income, you could instead focus your energy just on paying down debt. Strategies for decreasing your debt can be as aggressive as downsizing to a smaller house or trading for a more budget-friendly car, all the way to simply paying a little extra each month toward credit card debt. Even small steps help to move you in the right direction.

If you’ve run the numbers, and find your debt-to-income ratio is too high, and none of the above suggestions make sense for you, give one of our experienced team members a call. No financial situation is beyond repair. Our experts at American Credit Foundation can help answer all of your questions and discuss real ways you can improve not only your debt to income ratio but your overall financial health.

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