What is a good debt ratio and why is it important? | Mortgages and advice
A good debt-to-equity ratio is essential for loan approval, whether you’re looking for a mortgage, car loan or line of credit. This ratio shows lenders how much debt you have relative to the income you earn.
“The DTI ratio is the relationship between your scheduled monthly payments and your gross monthly income, expressed as a percentage,” says credit expert John Ulzheimer, formerly of FICO and Equifax.
The bottom line: Your DTI ratio helps a lender determine if you can afford a new loan payment.
Read on to learn more about how to calculate DTI, why you need a good DTI, and whether yours makes a difference.
What is a debt to income ratio?
Your DTI ratio is a snapshot of monthly debt to income.
Your debts include mortgages, car loans, and credit cards, but not expenses such as rent, utilities, daycare, and car insurance.
What counts as income in your DTI ratio? The DTI calculation uses your gross monthly income, or the amount you earn each month before taxes and other deductions. Sources of income can include wages, salaries, tips and bonuses, pensions and social security payments.
Child support and alimony are considered debts if you make these payments and income if you receive them.
Why is your debt ratio important?
Your DTI is important because it tells lenders if you’re managing your debt responsibly, and a low DTI ratio can put you in a good position to take on new debt.
Mortgage lenders use DTI to calculate how much home you can buy and whether to approve your loan, says Dave Krichmar, a Houston mortgage banker.
A lender may have concerns about your ability to repay a new loan if you’re struggling with debt repayments that are higher than you can comfortably afford. When your DTI ratio is too high, lenders are not likely to approve you for credit because they know you are overburdened and less likely to pay reliably.
How to Calculate the Debt-to-Income Ratio
You can calculate your DTI ratio in four steps:
1. Add up your monthly debt payments.
2. Calculate your gross monthly income. If your income varies, estimate the income for a typical month.
3. Divide your total monthly debt payments by your gross monthly income.
4. Multiply your answer by 100 to get your DTI ratio as a percentage.
Let’s say your gross monthly income is $7,000 and your debt is $3,000: $2,000 mortgage payments, $500 car loan, $300 student loan, and $200 credit card credit. Monthly debts of $3,000 divided by gross monthly income of $7,000 equals 0.429. Multiply by 100 to get 42.9%, or a DTI ratio of 43%.
If you’re looking for a mortgage, use your potential new mortgage payment to calculate your DTI. If you are replacing your mortgage with another loan, do not add your old payment to the new one.
The Consumer Financial Protection Bureau has a DTI calculator this can help simplify your calculations. If you’re not confident in calculating your DTI, you can also seek help from an expert, such as a mortgage broker or loan officer, Krichmar says.
Getting confused or looking at the wrong numbers is easy to do, he says. For example, clients incorrectly used their take-home pay instead of gross income to calculate DTI, Krichmar says.
What is a good debt to income ratio?
When it comes to DTI, the lower the ratio the better, says Ulzheimer. “It means you can take on new debt more easily because you have the ability to make the payments,” he says.
A good DTI ratio is 43% or less, Krichmar says. How do lenders see your DTI ratio?
- 35% or less: Your score is solid. You probably have money left over after paying your bills.
- 36% to 49%: You have room to improve. You manage your debt well, but a financial emergency could spell trouble. A lower DTI could put you in a better position to borrow or deal with unforeseen circumstances.
- 50% or more: You have work to do. If more than half of your income is spent paying off your debts, money is scarce. Your borrowing options may be limited because you cannot afford new debt.
How to lower your DTI ratio
To lower your DTI ratio, “you reduce your monthly obligations, increase your gross monthly income, or a combination of the two,” Ulzheimer says.
The easiest way to reduce your monthly debt burden is to pay off high balances and pay off other balances, says Janice Horan, vice president, Fair Isaac Advisors Global Credit Lifecycle Practice at FICO. “The other way is to make sure you’ve included all sources of income or to make sure you’ve included all recent increases in income,” says Horan.
Krichmar says you can lower your DTI ratio by paying more for your credit card debt or by refinancing loans to lower your monthly payments.
Other actions that can move your DTI ratio in the right direction:
- Avoid taking on more debt. New debt can increase your DTI ratio unless you increase your income.
- Choose a strategy to pay off your debts. The snowball or debt avalanche methods can be helpful, but they are not your only choices. You might consider a debt consolidation loan, balance transfer card, or debt management plan, depending on your financial situation. Whatever you do, always pay more than the minimum on your credit cards.
- Look for ways to increase your income. Ask for a raise if you’re running late or considering taking a side job.
Does your DTI ratio affect your credit?
Your DTI ratio never affects your credit report or credit score.
“The DTI ratio is not included in the FICO score because verified income is not an available field in the credit bureau files that form the basis of the FICO score calculation,” says Horan.
In general, lenders view borrowers with higher DTI ratios as riskier than their peers with lower DTIs, Horan says.
Lenders may reject your loan application if your DTI ratio is too high, or you could end up with a low loan limit and a high interest rate.
If you have maxed out credit cards or high balances, it affects your DTI ratio and credit score, Krichmar says. But “your credit score doesn’t know how much you earn,” he says.