When asked about their credit score, many Americans can provide a quick, accurate range off the top of their head. When asked about their DTI ratio, those quick answers are replaced with quizzical looks.
If your credit score is the ‘resting heart rate’ of your financial health, then DTI ratio is the ‘maximum oxygen intake’. Knowing either in isolation can be useful, but knowing both gives you a much more holistic understanding of how things are going.
What is Debt-to-Income Ratio?
Whether you are applying for a mortgage, student loan, or auto loan, lenders want to evaluate your ability to repay a loan. Several metrics measure your “risk”, or the likelihood that you can repay the loan.
Debt-to-income ratio (DTI) is one of these metrics.
Your DTI ratio is all of your monthly debt payments divided by your gross or total monthly income, taken as a percentage.
Why is a DTI Important?
DTI gives lenders a better understanding of your ability to manage debt and whether you will be able to manage more debt incurred by a loan.
A lower DTI ratio indicates a good balance between debt and income, demonstrating that you can manage debt well on a month-by-month basis. On the other hand, a high DTI ratio shows lenders that you may be struggling to pay off debt, with a high percentage of your income already going towards repaying other debts.
Lenders prefer to work with individuals with lower DTI ratios, as those on the higher end have higher default risk.
What is a Good DTI Ratio?
As a general rule of thumb, a lower DTI ratio is always better. A lower DTI ratio will increase your chances of loan approval, potentially decrease interest rates, and serve as proof of your overall financial wellbeing.
When it comes to a home loan, 43% is the highest DTI ratio a borrower can have and still qualify for a mortgage. If more than 43% of your income is going towards paying off debt already, mortgage lenders are unlikely to approve your request for a loan.
DTI ratios influence other areas of your financial world as well. For example, if you are applying for a credit card, your DTI ratio can impact your interest rates. An individual with a DTI ratio of around 60% might expect high interest rates, whereas a ratio below 20% will potentially score competitive, low interest rates.
How to Calculate Your Debt-to-Income Ratio
Knowing your DTI ratio is the first step towards effectively managing it, and increasing your likelihood of being approved for a loan.
Calculating your DTI ratio is a simple 2 step process.
Step 1 – Add Up All of Your Monthly Debts
To calculate your DTI ratio, you will need to know exactly how much you spend each month paying off your debts. This includes:
- Mortgage payments or rent
- Auto payments
- Student loans
- Credit card payments
- Personal loans
- Any other debt payments that show up on your credit report
Step 2 – Divide the Sum of Your Monthly Debts by Your Gross Monthly Income
Take the sum of your monthly debts and divide it by your gross monthly income, or your take-home pay before taxes or any other withholdings are taken out.
DTI Ratio Calculation Example
Let’s say you pay $1,000 each month for rent, your auto loan is $200, and your student loans and various other debts are $300. This means your total debts come out to $1,500.
If your salary is $60K, this means your gross monthly income is around $5,000.
Now, you’re considering applying for a mortgage so that those rent payments turn into mortgage payments, giving you a more secure financial future.
All you need to do to calculate your DTI ratio is the following:
(1,500/5,000) = 0.3 (30%)
Since your DTI ratio is 30%, a respectable number well below the 43% marker, you’re likely to qualify for that mortgage loan!
Front-End vs Back-End DTI
You may come across these two different ratios. They are simply separate components of the same ratio.
- Front-end ratio is the percentage of your gross monthly income going specifically towards housing expenses. For this reason, it’s often also called the ‘housing ratio’. Housing expenses include monthly payments on your mortgage, rent, homeowners insurance, and property taxes.
- Back-end ratio is the percentage of your income needed to cover your monthly debt obligations, plus mortgage and housing. This includes credit card bills, auto loans, student loans, or any other forms of revolving debt you are responsible for every month.
In our example above, the front-end ratio would be 20% and the back-end ratio would be the full 30%.
As for these two ratios, lenders prefer front-end DTI ratios below 28% and back-end DTI ratios at 38% or lower.
If your salary is 60K, this means you should be spending $1,900 or less towards paying off your debts, with $1,400 of that going towards housing. Any higher and you may negatively impact your front-end DTI ratio.
How to Lower Your Debt to Income Ratio
Get started lowering your DTI and boosting your chances of receiving a loan with these debt management tips!
Make a Plan to Pay Your Debts
This may sound simplistic, but many people simply pay their debts without actually strategizing how to do so in the most effective, and quickest, way possible.
Two popular strategies may be useful in tackling your debt:
- The Snowball Method is essentially paying your debts off in order from smallest to largest. Pay the minimums on all debts, and put any excess cash towards eliminating your smallest amount of debt entirely. Once the smallest is gone, move on to the second smallest.
- The Avalanche Method involves paying debts based on interest rates. Put the majority of your budget towards paying off debts with the highest interest rates first. This is useful if you have any high-interest loans.
Practice Smart Budgeting
Budgets aren’t exactly fun, but they are one of the most effective debt management tools in existence. Did you know that Fortuna Credit offers free budget planning tools? Check the “My Wallet” tab to see a summary of your saving and spending habits.
To effectively tackle your debt, you need to understand your entire financial situation. Only by taking stock of everything will you be able to strategize, finding areas of inefficiency.
By taking savings in multiple areas of your monthly expenses and funneling them into your debt management, you’ll be amazed at how quickly your DTI can improve.
Spend one or two months carefully measuring and tracking your expenses, and then work towards optimizing your budget. If you’re spending too much in a certain area, find a strategy for cutting back. Cooking at home instead of eating out several nights a week, for example.
Just imagine how much better than takeout sushi will taste in your own kitchen after you qualify for a mortgage.
Avoid Taking on More Debt
The strategies we’ve discussed up to this point will only lower your debt-to-income ratio, provided that you don’t incur more debt.
If you manage to budget effectively and pay off a debt that was costing you $100 per month, but then you take out an auto loan for $200 per month, your DTI ratio will actually get worse.
As difficult as it might be, prioritize paying off your debts first. Your future self will thank you.
Recalculate Your DTI Ratio Monthly
Management strategist Peter Drucker reportedly said: “If you can’t measure it, you can’t manage it.” And if you can’t manage it, you can’t improve it.
We’ve covered how to measure your DTI ratio, and given some practical tips for improving it. Going back and measuring your DTI ratio each month will let you know if your strategies are effective, or if they need to be optimized.
Say, for example, you start out using the snowball method. You manage to pay off some of your smaller debts, but when you measure your DTI, it hasn’t improved to the extent you’d hoped.
Upon further inspection, you notice a high-interest debt that is causing problems. It might then make sense to switch from the snowball to the avalanche method and knock that high-interest debt out first.
Does DTI affect credit?
Although DTI does not directly impact your credit score, the credit utilization ratio is a debt-to-credit measure used to calculate your credit score. To calculate the credit utilization
ratio, you take the amount of revolving credit (such as credit card debt) you’re using divided by the total amount of credit available to you.
DTI and the credit utilization ratio use different types of debt. Whereas DTI uses monthly recurring obligations like rent, auto and student loans, or child support, revolving credit includes debt that may not repeat each month.
Improving Your Chances
While credit scores typically steal the spotlight, your DTI ratio is another important metric that speaks to your financial health.
Unlike credit scores, however, DTI ratios can be measured easily and improved quickly. The calculator and tips we’ve covered here will help you understand your own DTI ratio, and how to effectively lower it.
Measuring, tracking, and improving your DTI ratio will improve your financial health and offer more financial tools at your disposal. For an easy way to stay organized and track your finances, take advantage of the free tools provided by Fortuna Credit.
*Any opinions expressed are those of Fortuna Credit and have not been reviewed or approved by any of our partners.
