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

You must understand the concept of a debt-to-income ratio and how it impacts your personal finances. The debt-to-income ratio DTI is the calculation of your total monthly debt payment divided by your gross monthly income. Other monthly bills, financial obligations (housing costs, transportation costs, and clothing cost)  are not a part of DTI. Knowing your DTI is extremely important for a number of reasons. For one thing, lenders often use it to determine if you can pay back a loan along with your credit history. When seeking out help from a lender, each one will have its own minimum DTI requirement in its loan terms. Overall, personal loan providers accept higher DTIs than mortgage lenders. Calculating your DTI is easy to do yourself, but it can be hard to understand its importance. Also, there is a DTI calculator. Here is everything you need to know about the debt-to-income ratio and why you should care about it.

Calculate Your DTI

Before you calculate your debt, gather your key financial information. You’ll need your auto loan payments, student loan payments, credit card, minimum payments, or any other related information. From there, you can get an idea of what your gross monthly income may be. After you have all the information you need, add up your monthly debt payments and divide them by your gross monthly income. Your gross monthly income includes the money you earned before taxes and other deductions. This includes your salary, wages, tips, and other income. For example, if you owe $1,200 for your monthly mortgage payment, $109 a month for homeowners insurance, and $150 for auto insurance, that totals to about $1,500. When dividing your debt payments by your gross monthly income totaling $6,000, that gives you a calculation of 25%. If this were a true DTI, it would be rather low. The higher the number, the more that there is a sign of financial insecurity. Those with a high DTI may struggle to make monthly payments. Monthly payments include basic expenses and the monthly budget you set for living in a month. The only monthly payments that you should put in your DTI calculation are those that are regular, recurring, and required.

DTI Guide

Use this guide to understand how to evaluate and use your current DTI.

• 35% or Lower: Your debt is very manageable, which means that you should have little to no difficulty receiving new credit.
• 35% to 40%: Once you have reached this level of debt, borrowers may be hesitant to lend you money. If you have reached this point, you still have a very good chance of paying most of it off before it gets too difficult. First, pay off what you owe. Then, reapply after lowering your DTI.
• 50%: It’s going to be extremely difficult to obtain a loan once you have gotten to this point. Instead of trying to pay off what you owe, find the primary sources of debt. For example, if it is mainly coming from credit card debt, see if you can sign up for a debt management plan to reduce your interest rates.
• Above 50%: It will be extremely difficult to pay off this amount of debt, and you will have limited borrowing options. At this point, it will be imperative that you work with a debt management program, consider debt-relief options, or file for bankruptcy.

DTI vs Credit Score

The DTI does not impact the credit score. Free credit reports examine your income, key personal information, and your current financial information. However, they do not include your DTI. The credit utilization ratio affects your credit score. This is the amount of credit you’re using in comparison to your limits. Your DTI reflects credit debt. The higher the borrower’s DTI, it may affect in linear with high credit utilization ratio.

How Lenders Utilize Your Debt-to-Income-Ratio

Lenders will look at your DTI to determine how much they will give you for a loan. The higher your DTI, the less likely a lender approves you for a loan. Most lenders have a minimum DTI requirement, while others are more lenient. However, mortgage lenders are even less likely to give you money unless your DTI is below 43%. If you have a higher DTI number and desperately need a loan, personal loan providers might be your best option, as they allow people to borrow with DTIs as high as 50% or more.

The Importance of DTI

If you want to repay a loan, lower your debt, or apply for a mortgage or FHA loan, focus on lowering your DTI. If you have a DTI  above, 50% lower your debt by buying on a budget, lowering your credit card interest, or using debt repair methods to reduce interest rates. Knowing your DTI gives you the opportunities to do all of the things you dream of, whether that be buying a new car, investing in a house, or going back to school. Once you know your DTI, you can work to improve it. Having a lower DTI makes it easier to apply for loans.