When it comes to your personal financial roadmap, do you know how much you’re making each month and how much you owe? Your income relative to debt owed—also known as a debt-to-income ratio (DTI)—is an essential metric a lender will use to judge your ability to manage your finances and, ultimately, repay a loan.
When you apply for a loan or line of credit, banks or credit unions will first review your DTI to determine whether you make enough money to cover both your monthly expenses and debts. In general, creditors tend to view borrowers with higher DTIs as riskier. But if you have a high DTI, you can fix that.
Here’s what you need to know about debt-to-income ratios.
What Is a Debt-to-Income Ratio?
Your DTI compares your income to the amount of debt you carry to determine what percentage of that income is being used to pay off debts each month.
For lenders, if a larger portion of your income is already being spent on existing debts, there’s a lower likelihood that you’ll be able to consistently make payments on your new loan or line of credit, which means a higher risk of default. Conversely, if you don’t have debt or only have a little debt, you’re in a better financial position to take on new debt.
Lenders tend to prefer less risky borrowers. As a result, banks and credit unions are more willing to extend credit to those individuals with a low DTI.
How Do You Calculate DTI?
According to the Consumer Financial Protection Bureau (CFPB), your DTI is all of your monthly debt payments—such as a mortgage, student loans, credit card payments, auto loans, child support, alimony, etc.—divided by your gross monthly income. Gross monthly income is the amount of money you have earned prior to taxes and other deductions.
You can either perform this process manually or use a debt calculator to determine your DTI.
For example, let’s say you have a monthly student loan payment of $500, credit card debt of $300, and a car payment of $350.
Your total monthly debt payments would be: $500 + $300 + $350 = $1,150.
If your gross income for the month is $4,000, your debt-to-income ratio would be 28.75% ($1,150 / $4,000 = 0.2875).
However, if your gross income for the month was lower, say $3,500, your DTI would be 32.86% ($1,150 / $3,500 = 0.3286). But if your gross income was higher, say $5,000, your DTI would be a lower 23% ($1,150/$5,000).
Naturally, your earning potential plays a significant role in your DTI and can potentially impact your ability to qualify for a new loan.
What is a Good DTI?
A debt-to-income ratio functions similarly to a credit score. Both demonstrate your financial trustworthiness to lenders.
What makes for a “good” DTI is subjective since every lender will have its own preferred DTI level, analysis criteria, and distinct method for computing this ratio. That said, generally speaking, DTI can be broken up into three tiers:
- 35% or less (Good) – A sub 35% DTI indicates that you have a manageable amount of debt relative to income. Individuals in this category shouldn’t have trouble acquiring a loan or a new line of credit.
- 36% to 49% (Okay) – A DTI in this range indicates that you are managing debt adequately but could take steps to reduce your DTI to protect yourself from an unexpected expense. At this stage, lenders may ask for additional eligibility criteria to better gauge your ability to repay your debts.
- 50% or more (Bad) – At this point, more than half of what you make before taxes is spent on servicing your debts, which indicates that you may have trouble keeping up with payments. With this ratio, lenders will likely view you as a high-risk borrower and may either deny the request altogether or set unfavorable terms such as a higher interest rate.
Why Does DTI Matter?
Put simply, your debt-to-income ratio is a quantitative representation of your riskiness as a lender. Having a lower DTI creates the following benefits:
- More likely to be approved for a loan – Lenders prefer less risky borrowers. On average, an individual with a good DTI is more likely to receive a loan than an individual with an okay DTI.
- More favorable terms – Because you’re less likely to default on the loan, lenders may be more willing to provide favorable terms such as a lower interest rate, higher credit limits, or longer repayment terms.
- More financial stability – When a smaller percentage of your income is devoted to paying back debt, you have more wiggle room in your budget to take on a new loan, pursue a financial goal, or weather an unforeseen emergency expense.
- Improved credit score – Your DTI—i.e. credit utilization ratio—is a significant factor in your credit score.
How Can I Improve My DTI Quickly?
If you’re in a pinch and need to improve your DTI, you typically have one of four options:
- Pay down your debts – The best way to reduce your DTI is to pay off your existing debts. While this may be easier said than done, consider using the debt avalanche method where you focus on paying the debts with the highest interest rates first while making minimum payments on the other debts.
- Increasing your earnings – As we saw in our example, a higher gross income will reduce your DTI. You can increase your earnings by asking for a raise, finding a new job, or taking on temporary work.
- Consolidate your debts – If you have several high-interest debts, consolidating them into a single loan or credit card can help you lower your interest rates, monthly payments, and simplify the payment process, making you less likely to miss making a payment.
- Refinance your debts – If interest rates are more favorable now than when you first acquired your loans, you may be able to refinance the debts to lower interest rates and reduce monthly payments.
The Bottom Line
DTI is a numerical representation of your fiscal health. The lower your debt-to-income, the more likely a bank or credit union will grant your loan, and do so with favorable terms. Fortunately, there are actionable steps you can take to improve your DTI.
If you’re searching for your next loan or line of credit, a credit union could be your best option. They tend to have less stringent DTI requirements and greater flexibility for their members.
CUselect makes it easy to find and join the best credit union for your financial situation. Shop around and compare rates from lenders across the country.
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