If you’re applying for a loan or a mortgage, one of the factors that lenders consider is your debt-to-income ratio.
Your debt-to-income ratio (DTI) is an important factor in the borrowing process and shows lenders your ability to pay back a loan.
What is debt-to-income ratio?
Your debt-to-income ratio refers to how much debt you have in relation to your income. This is an important consideration because when a lender approves a loan, they want to make sure you have enough income to pay back the loan.
If you have a lot of debt that takes up a good chunk of your income, it could be a warning sign.
How is debt-to-income ratio calculated?
According to the Consumer Financial Protection Bureau (CFPB), “Your debt-to-income ratio is all your monthly debt payments divided by your gross monthly income. This number is one way lenders measure your ability to manage the payments you make every month to repay the money you have borrowed.”
Your gross income is the amount of money you earn before any taxes or deductions are withheld. Your debt payments refer to the amount of money you spend each month on your loans.
Let’s say you earn $2,500 as your gross income. Each month you spend $200 on an auto loan, $250 on student loans, and $300 on credit cards. That means you’re spending $750 each month to manage your debt payments.
To figure out your debt-to-income ratio, you’d divide your debt payments by your gross income:
$750 ÷ $2,500 = .3
Take that number and multiply it by 100 to get your debt-to-income ratio, which in this case would be 30%. In other words, 30% of your income is going toward your debt obligations.
What is a good debt-to-income ratio?
If you have high debt loads and want to apply for a mortgage or other type of loan, you might be concerned about your debt-to-income ratio. Each lender will evaluate your DTI, so you want to know what yours is and if it will prevent you from getting a loan.
But what is a good debt-to-income ratio? A good benchmark is 36% or less. Many lenders use this metric as a way to assess a borrower’s DTI. The smaller the number, the better.
Having a low debt-to-income ratio can increase your chances of getting approved for a loan. When it comes to mortgages, 43% is usually the highest DTI that will allow you to qualify for a loan.
So if you want a hard and fast number to go by, 36% or lower is ideal. But the CFPB offers more specific debt-to-income ratios for certain situations.
For example, it recommends homeowners have a DTI of 36% or less (and absolutely not more than 43%), whereas renters should have a DTI of 15 to 20%.
Keeping your debt-to-income ratio as low as possible will boost your chances of obtaining a mortgage, auto loan, or other type of loan.
Lenders want to know that, given your current financial situation, you can afford to make payments on your current loans while also taking out a new loan.
Your income plays a big part in what you can afford and the amount you pay each month takes a bite out of your earnings. That’s why your DTI is such an important metric for lenders when assessing your eligibility.
How to lower your debt-to-income ratio
If you’ve done the math and your debt-to-income ratio is more than 36%, you’ll want to lower your DTI before applying for a loan. In order to lower your debt-to-income ratio, you have two options:
Pay off more of your debtEarn more
The first option will require you to pay more than the minimum on your debt. Don’t take out any additional debt and chip away at your current balances, so your debt is not taking out such a huge chunk of your income.
The second option is to increase your earnings. You can do that by negotiating your salary at your current job or finding a side hustle to bring in some extra cash.
Taking these steps to lower your balances and increase your income will help your DTI go down. Once your DTI goes down, you’ll be in a better position to apply for a loan.