What factors into debt to income ratio

Your debt-to-income (DTI) ratio is a comparison of your monthly debt payments with your monthly income before taxes. When you apply for a loan (a mortgage, for example), lenders look at your DTI ratio to determine if you can keep up with payments. As a general rule, the lower your DTI, the better a candidate you’ll be for a loan.

Read on to learn more about how to calculate your DTI ratio, why it’s important and ways you can lower it.

• How to calculate your debt-to-income ratio
• Why does your debt-to-income ratio matter?
• Does your debt-to-income ratio impact your credit?
• How to lower your debt-to-income ratio

How to calculate your debt-to-income ratio

Debt-to-income ratios are calculated with this formula: Monthly debt payments ÷ Monthly gross income = DTI ratio.

For example, let’s say you owe a total of $500 in debt payments every month, while your pre-tax monthly income is $2,000. Simply divide 500 by 2,000 (and multiply by 100 to turn the decimal into a percentage), and you’ll see that your DTI ratio is 25%.

Note that some lenders will include your housing payments when adding up your debt payments, while others will leave it out. To determine what to include in your monthly debt payment amount, you need to know if lenders are evaluating your front-end ratio or back-end debt-to-income ratio. The difference lies in whether they include housing costs:

• Front-end debt-to-income ratio: Your housing expenses, such as rent payments, mortgage payments, homeowners insurance and property taxes.
• Back-end debt-to-income ratio: Excludes housing expenses. Most lenders use this type of ratio in their calculation.

Calculating your DTI ratio: Start by adding up all the debt payments you make in a month, including student loans, car payments, credit card bills, alimony, child support and others. If you’re calculating your front-end debt-to-income ratio, only include what you pay for your rent or mortgage, including property taxes and insurance. (Do not include other monthly expenses, such as your electricity bill, gas or groceries.) Once you have the total, divide that number by your gross monthly earnings, which is the amount you make before taxes and other deductions, to get your DTI ratio.

High debt doesn’t always mean a high DTI ratio

Owing a large amount of money doesn’t necessarily mean you’ll have a high DTI ratio; it depends on what you earn and how much of your income goes toward debt repayment.

As an example, if you owe $1,000 in monthly debt payments and have a gross monthly income of $2,000, your DTI ratio will be high at 50%. However, if your gross monthly income is $10,000, your DTI ratio is only 10%.

In other words, your debt payments need to remain in proportion to your monthly income to remain affordable. But if your income is on the low side, it’s easier for your DTI ratio to creep up quickly.

Why does your debt-to-income ratio matter?

Your DTI ratio comes into play in a number of circumstances.

You need a good debt-to-income ratio to buy a house or finance a car

Your debt-to-income ratio measures the portion of your monthly income that is taken up by debt payments — as such, it gives lenders insight into your financial habits and your riskiness as a borrower, and can make a difference in whether you get approved for a mortgage or other types of financing.

Typically, in the case of a mortgage, your debt-to-income ratio must be no higher than 43% to qualify. That is the highest ratio allowed by large lenders, unless they use other factors to determine that you can repay the loan. A small creditor may offer mortgages to borrowers with higher DTI ratios, however.

While your DTI ratio is almost always a factor in whether you qualify for a mortgage, it might not be as important for other types of loans. Borrowers with high credit scores may be able to qualify for a personal loan or auto loan just by showing proof of employment and income. However, if you have a low credit score, your DTI ratio may need to meet requirements that are even stricter than those of a mortgage, depending on the lender.

A high DTI may make it difficult to juggle bills

Spending a high percentage of your monthly income on debt payments can make it difficult to make ends meet. A debt-to-income ratio of 35% or less usually means you have manageable monthly debt payments. Debt can be harder to manage if your DTI ratio falls between 36% and 49%.

Juggling bills can become a major challenge if debt repayments eat up more than 50% of your gross monthly income. For example, if 65% of your paycheck is going toward student debt, credit card bills and a personal loan, there might not be much left in your budget to put into savings or weather an emergency, like an unexpected medical bill or major car repair.

One financial hiccup could put you behind on your minimum payments, causing you to rack up late fees and potentially put you deeper in debt. Those issues may ultimately impact your credit score and worsen your financial situation.

Does your debt-to-income ratio impact your credit?

Your DTI ratio doesn’t directly impact your credit, since your income isn’t a factor in the calculation of your credit score. However, a high DTI often goes hand-in-hand with a high amount of debt, which does impact your score. In fact, “amounts owed” makes up 30% of your FICO Score.

“Amounts owed” refers to how much debt you owe, as well as how much of your available credit you’re utilizing. If you owe $2,000 on your credit cards and have a $4,000 limit, for example, then your credit utilization is 50%. It’s usually considered best to keep your credit utilization at no higher than 30% if you’re applying for a mortgage.

If you can lower your amounts owed, you’ll also likely boost your credit score and lower your DTI because you’ll be paying down debt.

How to lower your debt-to-income ratio

If your DTI is too high, consider these strategies for lowering it:

• Work on paying down debt
• Focus on increasing your income
• Open a debt consolidation loan or balance transfer credit card

Work on paying down debt

Paying off loans and bringing down debt balances can improve your debt-to-income ratio. To free up cash flow you can use to pay down your debt faster, give your budget a second look.

You may find ways to cut down on monthly expenses such as by:

• Calling your car insurance provider and asking for a lower rate
• Shopping for a lower-cost cell phone plan
• Reducing how often you get food delivery or takeout
• Canceling streaming services you no longer use

When deciding which debt to pay down first, borrowers often use one of two strategies. The debt avalanche method involves targeting your highest-interest debt first, while continuing to make minimum payments on all other debts. This strategy helps you save money on interest over time. The other method, debt snowball, has borrowers focus on the debt with the lowest balance first, while keeping up with the minimum payments on other debts. It helps borrowers stay motivated by giving them small wins on their path to getting out of debt.

If you’re unsure how to approach your debt, you could sign up for free or low-cost debt counseling with a certified credit counselor. These professionals can provide personalized financial advice, help you create a budget and provide useful tools that can teach you about money management. You can search for a certified credit counselor through the Financial Counseling Association of America (FCAA) or the National Foundation for Credit Counseling (NFCC).

Focus on increasing your income

Boosting your income can also help you work toward an ideal debt-to-income ratio. If you’re overdue for a raise, it might be time to ask your boss for a salary increase. You could also pick up a side job, such as tutoring, freelancing in a creative field or working as a virtual admin, to increase your earnings. Those looking to make a more extreme change might seek out a new company or career path.

Finding ways to make more money will not only help you get the right debt-to-income ratio for a personal loan, mortgage or another type of financing, it can also give you more financial stability. You may have more wiggle room in your budget to build an emergency fund and avoid taking on new debts.

Open a debt consolidation loan or balance transfer credit card

Debt consolidation may help you get a better interest rate and pay down your balances sooner, ultimately helping you bring down your debt-to-income ratio.

Two common strategies of consolidating debt is with a personal loan or a balance transfer credit card:

Click on this guide to learn more about the pros and cons of balance transfers.

What is factored into debt

What is excluded from debt

How can I lower my debt

What DTI do lenders look for?