What is Debt-to-Income Ratio and Why Does it Matter?

What is Debt-to-Income Ratio and Why Does it Matter?
What is Debt-to-Income Ratio and Why Does it Matter?
Finance
| Jul 07 2022
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Debt-to-Income Ratios: Your Guide Paying Down Debt

If you have ever applied for a loan, you have likely come across the term debt-to-income ratio. It is a very important factor in your personal finances and one of the key things that a lender will look at when determining whether or not to approve your loan.


Let’s talk about debt-to-income ratio and why it’s so important.


Why is debt-to-income ratio so important?

Your debt-to-income ratio is calculated by adding up all of your monthly debt payments and dividing them by your monthly gross income. The higher the ratio is (which means the more money you owe) the riskier the loan is perceived to be. The more debt you have, the more likely you are to be unable to make your monthly payments.


There are two components of your debt-to-income ratio that lenders will consider, your front end ratio and your back end ratio.


Your front end ratio, also called the housing ratio, looks at your income compared to your housing expenses. These expenses include your monthly mortgage payment, property taxes, homeowners insurance and any homeowners association fees you may be required to pay.


Your back end ratio looks at your income compared to all of your monthly expenses, including your mortgage and other housing expenses. It also includes your student loans, credit cards, car loans, and any other expenses you may have.


Your DTI ultimately shows lenders how you handle your debt and how capable you are to pay back your debts. The higher your DTI is, the less likely a lender will approve you for a loan.



How is my debt-to-income ratio calculated?

To calculate your debt-to-income ratio, you first need to add up all of your monthly expenses. Some examples include:


  • Mortgage payments
  • Insurance payments
  • Credit card minimums
  • Car payments
  • Student loan payments
  • Personal loan payments


Once you have your total expenses calculated, divide that number by your monthly gross income–your income before taxes and other deductions. That number is your DTI.


Let’s say your monthly expenses are as follows:


  • Mortgage payment: $3000
  • Credit card minimums: $150
  • Car payments: $400
  • Student loan payments: $600
  • Personal loan payments: $300


Your total monthly debt adds up to be $4,450. If your monthly income is $13,000, then your DTI is 34%.


Note that it includes your minimum credit card payments, but not your credit card balance or any other variable expenses, like groceries. In other words, this ratio gives lenders a good idea of what your basic monthly expenses are, but it's not necessarily a good indication of what you can afford. Qualifying for a $40,000 car loan does not mean that you can necessarily afford the payments.



What is considered a good debt-to-income ratio?

While these ratios will vary from lender to lender, there is a general consensus on what constitutes a good DTI. You should aim to have a front end debt-to-income ratio that is below 28%–this means that all of your housing expenses take up less than 28% of your monthly income. You should aim to have a back end debt-to-income ratio of less than 36%–this means that all of your expenses, including housing, take up less than 36% of your monthly income.


All lenders have different requirements, and your DTI is certainly not the only factor they are looking at. If you have an excellent credit score but a slightly higher DTI, a lender might not view you as a risky candidate. If you have a higher DTI, you might not qualify for as low of an APR. Some conventional loans, like Fannie Mae, accept loan applicants with ratios as high as 50%. It really does depend on a lot of factors, but the lower your DTI ratio is, the more likely you will get a favorable loan.



How can I reduce my debt-to-income ratio?

If your debt-to-income ratio is higher than you would like, there are a few things you can do to lower your ratio.


Create a Budget

Take the time to map out a realistic and easy to track budget. Take a detailed inventory of all of your expenses, from the boxed meal prep kit you got talked into to the electricity bill that keeps ticking higher and higher. Only when you look at all of your expenses listed out will you see how much you are truly spending. Compare your expenses to your income to see how it is measuring up. Are your expenses outpacing your income, or are you able to save a bit each month? 


If you have extra money every month, you should prioritize starting an emergency fund (if you don’t already have that). After that, look to allocate extra money to your debts. Look for ways to cut down on your spending–any money you save can be used to paying down your debts.


Creating a budget can be difficult, so it’s important to attach goals to your budget to help keep yourself motivated. It can also be helpful to tell a friend or loved one about your budget so that you will have someone else to hold you accountable.


Strategize Paying Off Your Debt

There are a lot of different ways that you can go about paying off your debt. Here are a few different strategies you can use to pay down your debt:


  • The Snowball Method. Pay down your smallest credit balance first while only making minimum payments on the others. Once you pay off the smallest one, go to the next smallest and pay that one down while making only minimum payments on the others. Repeat until you have paid off all of your debt.
  • The Avalanche Method. Focus on the accounts with the highest interest rates first. If you have three loans with respective interest rates of 18%, 13%, and 8%, prioritize paying down the first loan while making minimums on the others. When that one is paid off, move on to the second loan, and so on, until all of your debt is gone..
  • Debt Consolidation. Another option is to use a debt consolidation service to move all of your debt to one account, and make payments on that. This will depend on what types of loans you have and what interest rates you can secure.


There are some other simpler methods for paying off debt as well. These include:


  • Paying an additional amount above the minimum on every balance every month.
  • Making an extra payment every few months.
  • Get a balance transfer credit card.



Refinance Your Loans

One great way to help reduce your DTI is to refinance your loans. Refinancing your car loan or mortgage can help you in a few ways. When you refinance, you will be able to change your repayment period on the loan. For instance, instead of a 48 month car loan you can refinance to a 36 month car loan. This means you will be paying your debt off at a faster rate, reducing your DTI at a faster rate. Shortening your repayment period often comes with lower car loan APRs as well. Your monthly payments will be a bit higher, but if you can afford that adjustment it will greatly help your DTI and credit score in the long run.


If your credit score has improved since you initially financed your car or your home, or if the market rates have decreased since you initially financed, you may qualify for a significantly lower APR. This can save you a lot of money, money that you can use to pay off other debts.


Avoid Taking on New Debt

This may be obvious, but try your best to avoid getting into more debt. Limit your purchases, resist opening new lines of credit, and avoid any major purchases. 


Look to Increase Your Income

If you feel like you are in the weeds when it comes to your debt, look to increase your income. Perhaps you can pick up a side job or increase the hours where you currently work. Whatever your situation is, finding a way for your income to outpace your expenses is key.



That’s everything you need to know about your debt-to-income-ratio and why it’s so important.


Applying for a new loan can be stressful, so it’s important to be as prepared as possible. One way to prepare for your application is to calculate your DTI to see how you stack up. If your DTI is above 36%, you may have a more difficult time finding a lender. If you are able to delay the process, devote your time and energy to reducing your DTI ratio. This will most likely cause your credit score to increase as well. This will make you a much more desirable loan candidate as you move forward.


Refinancing your car loan is a great way to help lower your DTI and increase your credit score. If car refinance sounds like a good option for you, Auto Approve may be able to help you. They have relationships with lenders across the country, which helps them secure the most competitive rates on the market. Simply contact us to see how much money you could be saving!


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