A debt-to-income ratio(DTI) is a personal finance measure that compares the amount of debt you have to your overall income. It shows how much of your money is spoken for by debt payments and how much is left over for other things.
Lenders, including anyone who might give you a mortgage or an auto loan, use DTI as a measure of creditworthiness. DTI is one factor that can help lenders decide whether you can repay the money you have borrowed or take on more debt.
A good debt-to-income ratio is below 43%, and many lenders prefer 36% or below. Learn more about how debt-to-income ratio is calculated and how you can improve yours.
Key Takeaways
- Your debt-to-income ratio shows what percentage of your available income is already going toward paying off debt.
- Lenders look for low debt-to-income (DTI) figures because borrowers with more available income are more likely to successfully manage new monthly debt payments.
- Credit utilization impacts credit scores, but not debt-to-credit ratios.
- Creating a budget, paying off debts, and making a smart saving plan can all contribute to fixing a poor debt-to-credit ratio over time.
Understanding Debt-to-Income Ratio
Your debt-to-income ratio shows how much of your available income is already needed to pay off debts. A high DTI means that more of your money already goes towards debt repayment. A low DTI ratio indicates that you have more money available.
To lenders, a low debt-to-income ratio demonstrates a good balance between debt and income. The lower the percentage, the better the chance you will be able to get theloan or line of credit you want. A high debt-to-income ratio signals that you may have too much debt for the income you have. Lenders view this as a signal that you would be unable to take on any additional obligations.
Expressed as a percentage, a debt-to-income ratio is calculated by dividing total recurring monthly debt by monthly gross income.
How to Calculate Debt-to-Income Ratio
To calculate your debt-to-income ratio, add up your total recurring monthly obligations. These could include:
- Mortgage
- Student loans
- Auto loans
- Child support
- Credit card payments
For example, assume you pay $1,200 for your mortgage, $400 for your car, and $400 for the rest of your debts each month. Your monthly debt payments would be as follows:
$1,200 + $400 + $400 = $2,000
Divide this total by your gross monthly income. Gross monthly income is the amount you earn each month before taxes and other deductions are taken out.
If your gross income for the month is $6,000, your debt-to-income ratio would be 33%:
$2,000 / $6,000 = 0.33, or 33%
However, if your gross monthly income was lower, but your debts were the same, your DTI ratio would be higher. This would mean that a greater portion of your income is already needed to pay off existing debts. If your income was $5,000 per month instead of $6,000, your debt-to-income ratio would be 40%:
$2,000 / $5,000 = 0.4, or 40%
Good DTI for Getting a Mortgage
When you apply for a mortgage, the lender will consider your finances, including your credit history, monthly gross income and how much money you have for a down payment. To figure out how much you can afford for a house, the lender will look at your debt-to-income ratio.
Debt-to-income is one of many factors that lenders look at to decide whether or not your qualify for a loan.
Lenders prefer to see a debt-to-income ratio smaller than 36%, with no more than 28% of that debt going towards servicing your mortgage. For example, assume your gross income is $4,000 per month. The maximum amount for monthly mortgage-related payments at 28% would be $1,120:
$4,000 x 0.28 = $1,120
Your lender will also look at your total debts, which should not exceed 36%, or in this case, $1,440:
$4,000 x 0.36 = $1,440
This would mean that, if you have a $1,120 monthly mortgage payment, your other debts would need to be no more than $320:
$1,440 - $1,120 = $320
In most cases, 43% is the highest DTI ratio a borrower can have and still get a qualified mortgage. Above that, the lender will likely deny the loan application because your monthly expenses for housing and various debts are too high as compared to your income. The lender would worry that your expenses exceed your income and you are more likely to default on repaying the loan.
DTI and Credit Score
Your debt-to-income ratio does not directly affect your credit score. This is because the credit agencies do not know how much money you earn, so they are not able to make the calculation.
Credit agencies do, however, look at your credit utilization ratio or debt-to-credit ratio, which compares all your credit card account balances to the total amount of credit (that is, the sum of all the credit limits on your cards) you have available.
For example, if you have credit card balances totaling $4,000 with a credit limit of $10,000, your debt-to-credit ratio would be 40%:
$4,000 / $10,000 = 0.40, or 40%
In general, the more you owe relative to your credit limit, or how close you are to maxing out your credit cards, the lower your credit score will be.
How to Lower Your Debt-to-Income (DTI) Ratio
A debt-to-income ratio is made up of two parts, debt and income. Changing one of these two parts is the only way to change your DTI ration. You can either:
- Reduce your monthly recurring debt.
- Increase your gross monthly income.
Let's return to our example of the debt-to-income ratio at 33%, based on a total recurring monthly debt of $2,000 and a gross monthly income of $6,000. If your total recurring monthly debt were reduced to $1,500, your debt-to-income ratio would decrease to 25%:
$1,500 / $6,000 = 0.25, or 25%
If your debt stays the same as in the first example but you increase your income to $8,000, again your debt-to-income ratio drops to 25%:
$2,000 / $8,000 = 0.25, or 25%
You will see an even bigger change in your debt-to-income ratio if you can increase your income and decrease your debt at the same time.
Of course, reducing debt is easier said than done. It can be helpful to make a conscious effort to avoid going further into debt by considering needs versus wants when spending. Needs are things you have to have in order to survive: food, shelter, clothing, healthcare, and transportation. Wants, on the other hand, are things you would like to have, but that you don’t need to survive.
Once your needs have been met each month, you might have discretionary income available to spend on wants. You don’t have to spend it all, and if you are saving for a big expense, such as a mortgage, a new car, or retirement, it will make the most financial sense to put some of that discretionary income aside instead of spending it on wants.
You can also lower your spending by creating a budget that includes paying down the debt you already have.
To increase your income, you might be able to do the following:
- Find a second job or work as a freelancer in your spare time.
- Work more hours or overtime at your primary job.
- Ask for a pay increase.
- Complete coursework or licensing that will increase your skills and marketability, and obtain a new job with a higher salary.
Can You Get a Mortgage With a DTI Above 50%?
There are many factors that impact whether or not you can get a mortgage, and your DTI is just one of them. Some lenders may be willing to offer you a mortgage with a DTI over 50%. However, you are more likely to be approved for a loan if your DTI is below 43%, and many lenders will prefer than your DTI be under 36%.
Do Monthly Bills Count Towards My DTI?
Monthly bills, such as your cell phone or internet bills, do not count toward your debt-to-income ratio. This is because these expenses are not mandatory; you can cancel your cell phone or internet plan whenever you want if you need to save money. You cannot cancel debts without repaying them, which is why they are included in your DTI.
What Are the Limitations of the Debt-to-Income Ratio?
DTI reflects your total debt, but it does not reflect the types of debt and the different costs of repaying those debts. For example, if you had the balance of a high-interest credit card transferred a lower-interest credit card, your monthly payment would go down, even though the total amount you owe would be the same. This would mean your DTI decreases even though your debt has not actually decreased.
The Bottom Line
Your debt-to-income ratio shows what percentage of your available income is already going toward paying off debt. If you are trying to take out a loan, such as a mortgage, lenders prefer a low debt-to-income ratio because that means more of your income is available to handle new debt payments.
You can improve your debt-to-income ratio by reducing the amount of debt you have or increasing your income. You will see the biggest improvement in your debt-to-income ratio if you can do both at the same time.
