- Your debt-to-income ratio is the percentage of your monthly income that goes toward debt payments.
- Your DTI is one factor considered in lending decisions, especially mortgage decisions.
- A good DTI varies based on loan type, though you should keep it below 43%.
When you apply for a loan, creditors will scrutinize every detail to determine whether you're a good candidate to lend to. Besides looking at your credit score, payment history, assets, and cash flow, they also consider your debt-to-income ratio.
Understanding debt-to-income ratio (DTI)
Definition of debt-to-income ratio
Debt-to-income ratio (DTI) is the percentage of your monthly gross income that goes toward paying existing debts. Lenders look at this ratio to gauge your ability to repay the money you plan to borrow. A low DTI signals a good balance between debt and income, whereas a high DTI may be a sign that you're overextending yourself and are too risky to extend a loan to.
Mortgage lenders typically look at two types of debt-to-income ratios when evaluating your risk: front-end and back-end. It's worth noting that while the term "DTI" typically refers to the back-end ratio, both ratios can come into play when lenders assess your eligibility for a mortgage.
Front-end DTI
Also known as the housing ratio, front-end DTI measures how much of your monthly income goes toward housing costs. These housing costs can include expenses like mortgage payments, rent payments, property taxes, and homeowners association fees.
Back-end DTI
Back-end DTI calculates the percentage of your gross income that goes toward debt obligations. Unlike front-end DTI, back-end DTI takes into account all your debt repayments, not just those associated with housing. Your debts can include not only mortgage payments but also credit card payments, student loans, and auto loans.
How to calculate your debt-to-income ratio
Example of debt-to-income ratio calculations
Let's say your monthly gross income is $8,000. Your mortgage payment is $1,200. You also pay $300 in car loans, $200 in student loans, and $500 in credit card bills each month. In total, your monthly debt obligations add up to $2,200.
Step-by-step guide to DTI calculation
To calculate your front-end DTI, add up all your housing-related debt payments, then divide the total by your gross monthly income and multiply the result by 100.
Here's what the calculation looks like using the example above:
- 1,200/8,000 = 0.15
- 0.15 x 100 = 15%
To calculate your back-end DTI, add up all your monthly debt payments and divide this total by your gross monthly income. Then, multiply the resulting number by 100 to get a percentage.
Here's what the calculation looks like using the example above:
- (1,200+300+200+500)/8,000 = 0.275
- 0.275 x 100 = 27.5%
Be sure to double-check with your lender to see how they view rent in DTI calculations. Scott Bridges, senior managing director of consumer direct lending at mortgage company Pennymac, says that lenders generally don't consider your rent payments in DTI calculations when buying a primary residence. "This is because the lender will assume that the borrower will be moving out of their current rental property," he says.
However, Rose notes that this may change from lender to lender, as some may see your rent payments as a representation of how you deal with monthly commitments.
What is a good debt-to-income ratio?
Importance of DTI in financial health
Your DTI is a key indicator of your financial health, but "the acceptable DTI can vary depending on the loan type," says Jeff Rose, a Certified Financial Planner.
Recommended DTI levels for different loan types
You can have a DTI ratio as high as 43% and still get approved for a mortgage, though Rose says lenders would ideally like to see a total DTI ratio of 36% or less with 28% going toward housing expenses (front-end DTI). Personal loan providers prefer DTI ratios under 36%, while auto loan providers can be a little more lenient. "Each situation is a case-by-case basis, so verifying with the lender is always encouraged," Rose says.
How can I lower my debt-to-income ratio?
If your debt-to-income ratio isn't anywhere near the acceptable range, take steps to reduce it so that you won't face any issues when applying for loans in the future. Here's what you could do to lower your DTI.
Boost your income
While boosting your income is easier said than done, it's perhaps the most straightforward way to lower your debt-to-income ratio. Assuming that your debt obligations stay the same, the higher your income, the lower your debt-to-income ratio.
You can generate extra income by taking on a second job, freelancing, or starting an online business like selling digital products. If you're unable to make time for any of these, consider asking your current employer for a pay raise.
Eliminate your existing debts
By reducing the outstanding balances on your credit cards, loans, or other lines of credit, you decrease the total amount of your monthly debt payments. This directly impacts your DTI ratio by lowering the numerator, even if your income stays the same.
If you're struggling with debt repayment, the debt snowball or avalanche methods could help you make progress. The snowball method involves paying off your smallest debt first and then moving on to the next smallest, while the avalanche method focuses on targeting high-interest debt first.
Negotiate with creditors
If you haven't already, call your credit card companies and ask for a reasonable rate reduction. According to Rose, most creditors are open to negotiation and may be willing to knock your interest rates down a bit. "By negotiating a reduced balance or interest rate, you can decrease your monthly debt obligations and positively impact your debt-to-income ratio," he says.
While lowering your interest rates by a few percentage points may not seem like much, it could potentially save you thousands of dollars over the long run while you work on paying them down. This strategy works best if you have a record of on-time payments.
Consolidate your debts
Juggling multiple high-interest debts can take a toll on both your financial health and mental well-being. To ease your burden and lower your debt-to-income ratio as soon as possible, consider consolidating your debts.
One way to go about this could be getting a balance transfer credit card, which lets you transfer debts from high-interest cards and consolidate them under one lower interest rate.
Or, you could take out one of the best debt consolidation loans, an unsecured personal loan that allows you to roll multiple debts into a single payment, ideally at a lower interest rate.
Frequently asked questions about debt-to-income ratio
Your debt-to-income ratio (DTI) affects loan approvals by helping lenders determine if you can afford to take on additional debt, such as a mortgage loan or car payment. If your DTI is too high, you may not be approved for a loan or receive the best interest rates.
No, 50% is not a good debt-to-income ratio. With a 50% debt-to-income ratio, you'll struggle to qualify for any type of loan.
You can improve your debt-to-income ratio by reducing your debt, boosting your income, and, if necessary, negotiating with your creditors to reduce your interest rate or your balance.
No, your utility bills or phone bills do not factor into DTI calculations.
