If you have ever applied for a loan, you have likely come across the idea of a debt-to-income ratio. But what is a debt-to-income ratio, and why is it so important?
Your debt-to-income ratio (or DTI) is all your monthly debt payments owed divided by your gross income.
It matters because it’s one of the key things that a lender will look at when determining whether or not to approve your loan. Many lenders prefer applicants with a DTI below 36% and may refuse to lend to someone with a ratio over 43%.
Read on for a more in-depth explanation.
In this article, you’ll learn:
How a debt-to-income ratio (DTI) is calculated
Front end and back end ratios
What’s considered a good DTI
Why it matters
Strategies for reducing a high debt-to-income ratio
Your DTI is simple enough to calculate: you’ll need to add up all the payments you have to make in a given month on debt (like car loans, student loans, and mortgages) and divide them by your gross monthly income: the amount you make in a month before any deductions (like taxes) are taken out.
So, for example, let’s say you pay $200 on your car, $600 on your mortgage, and $150 on credit card debt every month, and you’re making $5,000 a month before deductions. Here’s what the calculation would look like:
($200 + $600 + $150) ÷ $5000
= $950 ÷ $5000
= 0.19
x 100 = 19%
You would have a debt-to-income ratio of 19%.
If you want 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
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. You can find this by taking your annual pre-withholding salary and dividing it by 12. If you’re not totally sure what your gross is, you can find it on a recent paycheck.
Let’s look at another example.
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 this calculation includes your minimum credit card payments, 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.
There are two components of your debt-to-income ratio that lenders will consider, your front end ratio and your back end ratio.
The calculations above give you an idea of your back end ratio. The 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 front end ratio, also called the housing ratio, looks at your income compared specifically 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.
Combining these gives lenders a fuller picture of your finances. The combined DTI numbers show lenders how you handle your debt and how able you are to pay back your debts.
The higher your debt-to-income ratio (DTI) ratio is, the riskier the loan is perceived to be, and the less likely a lender will approve you for a loan. That’s why lenders care so much about it.
If you’re carrying a lot of debt or your income isn’t enough to cover the debt you have, the more likely it is that you might miss payments.
While the specific numbers will vary from lender to lender, generally, to have a good debt-to-income ratio (DTI), you should aim to have:
a front end debt-to-income ratio below 28% – this means that all of your housing expenses take up less than 28% of your monthly income.
a back end debt-to-income ratio below 36% – this means that all of your expenses, including housing, take up less than 36% of your monthly income.
However, all lenders have different requirements, and your DTI is not the only factor they will be considering.
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%.
That said, the lower your DTI ratio is, the more likely it is that you’ll get a favorable loan.
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
Build a debt payback strategy
Refinance your loans
Avoid new debt
Increase your income
To make sure you’re spending within your means, 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 pay 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.
To reduce your debt-to-income ratio, you need to shrink your debt or increase your income – ideally both.
There are a lot of different ways that you can go about paying off your debt. Here are a few different strategies to consider:
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.
Getting a balance transfer credit card.
Refinancing your car loan or mortgage can help you reduce your DTI by helping you reduce how much you owe monthly, by reducing the total due across the life of the loan, or both.
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 money you can use to pay off other debts.
This may sound 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. It may be easier said than done, but avoiding add to your debt is crucial for your financial well-being.
If you feel like you are in the weeds when it comes to your debt, you can also shrink your debt-to-income ratio by increasing your income.
Consider looking for a side job or taking on more hours at work, if available to you. Whatever your situation is, finding a way for your income to outpace your expenses is key. Many people find that, at a certain point, it’s easier to increase income than trim expenses.
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 ratio 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 debt-to-income ratio and increase your credit score.
Read up to find out if refinancing your auto loan makes sense for you, or get a free, no-commitment quote and chat with one of our refinance experts to find out how much you might be able to save.
