What Is a Good Debt-to-Income Ratio?
Your debt-to-income (DTI) ratio compares your monthly debt payments with your monthly income before taxes. Lenders use your DTI ratio to gauge your ability to take on new debt and keep up with payments. As an example, a good DTI ratio to buy a house is 36% or less, but you may be able to get a mortgage with a DTI ratio as high as 50%. When it comes to other types of financing, a good DTI ratio can vary depending on the lender, the type of loan and your credit score.
Read on to learn more about how to calculate your DTI ratio, why it’s important and ways you can lower it.
How to calculate your debt-to-income ratio
Debt-to-income ratios are calculated with this formula:
Monthly Debt Payments ÷ Monthly Gross Income = DTI Ratio
To determine what to include in your monthly debt payment amount, you need to know if lenders are evaluating your front-end or back-end debt-to-income ratio:
- Front-end debt-to-income ratio: Includes your housing expenses, such as rent payments, mortgage payments, homeowners insurance and property taxes
- Back-end debt-to-income ratio: Excludes housing expenses. Most lenders use this type of ratio in their calculation.
High debt doesn’t always mean a high DTI ratio
Owing a large amount of money doesn’t necessarily mean you’ll have a high DTI ratio; it depends on what you earn and how much of your income goes toward debt repayment.
According to 2016 Survey of Consumer Finances data, people in the 90th-income percentile, where the median annual income is $260,000, tend to have the lowest DTI ratio (6.2%) of all income groups, even though they usually take on more debt in every category.
Put into perspective, that figure is 4.6 percentage points lower than the average American debt-to-income ratio of 10.8%. People in all other income percentiles have an average DTI ratio of about 14% to 16%.
Why does your debt-to-income ratio matter?
You need a good debt-to-income ratio to buy a house or finance a car
Debt-to-income measures the portion of your monthly income that is taken up by debt payments. It gives lenders insight into your financial habits and your riskiness as a borrower, and can make a difference in whether you get approved for a mortgage or other types of financing.
In the case of a mortgage, your debt-to-income ratio must be no higher than 43% to qualify. That is the highest ratio allowed by large lenders, unless they use other factors to determine that you can repay the loan. A small creditor may offer mortgages to borrowers with higher DTI ratios, however.
While your DTI ratio is almost always a factor in whether you qualify for a mortgage, it might not be as important for other types of loans. Borrowers with high credit scores may be able to qualify for a personal loan or auto loan just by showing proof of employment and income. However, if you have a low credit score, your DTI ratio may need to meet requirements that are even stricter than those of a mortgage, depending on the lender.
A high DTI may make it difficult to juggle bills
Spending a high percentage of your monthly income on debt payments can make it difficult to make ends meet. A debt-to-income ratio of 35% or less usually means you have manageable monthly debt payments. Debt can be harder to manageable if your DTI ratio falls between 36% and 49%.
Juggling bills can become a major challenge if debt repayments eat up more than 50% of your gross monthly income. For example, if 65% of your paycheck is going toward student debt, credit card bills and a personal loan, there might not be much left in your budget to put into savings or to weather an emergency, like an unexpected medical bill or major car repair. One financial hiccup could put you behind on your minimum payments, causing you to rack up late fees and potentially put you deeper in debt. Those issues may ultimately impact your credit score and worsen your financial situation.
How to lower your debt-to-income ratio
Work on paying down debt
Paying off loans and bringing down debt balances can improve your debt-to-income ratio. To free up cash flow you can use to pay down your debt faster, give your budget a second look.
You may find ways to cut down on monthly expenses such as by:
- Calling your car insurance provider and asking for a lower rate.
- Shopping for a lower-cost cellphone plan.
- Reducing how often you get food delivery or takeout.
- Canceling streaming services you no longer use.
When deciding which debt to pay down first, borrowers often use one of two strategies. The debt avalanche method involves targeting your highest-interest debt first, while continuing to make minimum payments on all other debts. This strategy helps you save money on interest over time. The other method, debt snowball, has borrowers focus on the debt with the lowest balance first, while keeping up with the minimum payments on other debts. It helps borrowers stay motivated by giving them small wins on their path to getting out of debt.
If you’re unsure how to approach your debt, you could sign up for free or low-cost debt counseling with a certified credit counselor. These professionals can provide personalized financial advice, help you create a budget and provide useful tools that can teach you about money management. You can search for a certified credit counselor through the Financial Counseling Association of America (FCAA) or the National Foundation for Credit Counseling (NFCC).
Focus on increasing your income
Boosting your income can also help you work toward an ideal debt-to-income ratio. If you’re overdue for a raise, it might be time to ask your boss for a salary increase. You could also pick up a side job, such as tutoring, freelancing in a creative field or working as a virtual admin, to increase your earnings. Those looking to make a more extreme change might seek out a new company or career path.
Finding ways to make more money will not only help you get the right debt-to-income ratio for a personal loan, a mortgage or another type of financing, it can also give you more financial stability. You may have more wiggle room in your budget to build an emergency fund and avoid taking on new debts.
Open a debt consolidation loan or balance transfer credit card
Debt consolidation may help you get a better interest rate and pay down your balances sooner, ultimately helping you bring down your debt-to-income ratio.
Two common strategies of consolidating debt is with a personal loan or a balance transfer credit card:
|Debt consolidation vs. balance transfer|
|Debt consolidation loan||Balance-transfer credit card|
|Definition||A personal loan used to pay off multiple existing debts.||A credit card that allows you to transfer existing debt from another credit card.|
|APR||9.63% on average.||As low as 0% APR if you pay off the balance within the introductory period, then 15.09% on average.|
|Terms||12 to 60 months.||12 to 21 months for 0% interest period.|
|Fees||Origination fee is equal to 0% to 8% of your loan amount.||Typically a one-time balance transfer fee of 3%.|