What's a Good Debt-to-Income Ratio & How to Calculate Yours
If you’re looking for financing for a home or new car, your debt-to-income (DTI) ratio can be almost as important as your credit score. But what is a good debt-to-income ratio and how do you go about calculating — and improving — yours?
Shortly, we'll take a closer look at what your DTI is, how it works and how it affects your ability to access the financing you need to reach important life goals. Read on to learn more! 😎
Owing vs. Earning: What’s a Good DTI?
If you have good credit but a high debt-to-income ratio, you may be surprised to find you’re charged a higher rate on loans or denied financing altogether. 😲
Let’s break down what your DTI is and how it affects your ability to access the credit you need.
What Is Your DTI?
Your debt-to-income ratio demonstrates the relationship between the amount of debt you owe and the amount of income you have. Put differently, it's the amount of your income needed to pay your debt each month.
Your DTI is calculated by dividing your total monthly debt payments by your gross monthly income to provide a percentage of your income that goes toward servicing your debt.
Types of DTI
Depending on the type of financing you need, lenders may look at your debt obligations in different ways to estimate how much risk they would take by giving you credit. The two most common types of DTI percentages are:
- Housing debt-to-income ratio: This looks at only one type of debt: housing or mortgage-related debt payments due monthly (principal and interest only). This figure helps lenders determine how affordable a property is in relation to your overall gross monthly income. Many lenders prefer your housing ratio to be significantly lower than your overall DTI.
- Overall or total debt-to-income ratio: This includes all your debt, including student debt, car loans, personal loans, lines of credit and credit cards. It provides an overall picture of your debt burden.
Why Should I Care About My DTI?
Your DTI plays a big role in your ability to access credit for important things like student loans, auto loans and mortgages. Even if you have a good income and good credit, you might be surprised to find you are denied financing because your DTI is too high. 📈
A “manageable” amount of debt is considered a common indicator of financial health. For example, if only 15% of your income goes towards debt every month, you're more likely to have flexibility in your budget and can save and spend with less stress.
Things like buying groceries, paying your utility bill and filling up the gas tank aren't as big of a deal if you don't have a staggering debt payment due each month as well. This also makes you less apt to be a risky borrower when you apply for a loan with a credit union or bank.
From the lender's point of view, having flexibility in your budget means you are less likely to default on your loan, lowering the risk involved in giving you credit.
So, What’s a Good DTI Ratio?
Broadly speaking, the lower your DTI ratio, the better your chances are for qualifying for a loan. However, the realities of affording a college degree, new car and a home mean that most people accumulate at least some debt to reach their financial and personal goals. ⚖️
Here’s how lenders look at debt loads:
Total DTI of 45% or more: With almost half your income or possibly more going to debt, lenders are going to be wary of extending you credit. Those that do are likely going to charge higher rates and might also require mortgage insurance.
Total DTI of 30-44%: It’s going to be tight, but you can handle your debt and take care of your other monthly expenses most of the time. Lenders will look more favorably on a good credit score and evidence of secure employment.
Total DTI below 30%: Ideal. You’re using some of your money to invest in property with enough left over for saving and spending. You’re likely able to secure a good rate and favorable terms from most lenders.
How to Calculate Debt-to-Income Ratio
Now let’s take a step-by-step look at how to calculate your DTI ratio.
Step 1: Figure Out Your Monthly Gross Income
This should be the amount of money you make each month before any taxes or deductions. This is not the same as your "take-home" pay which excludes tax deductions and other benefits you might receive. Take your annual gross income and divide it by 12.
Why is this important? Lenders want to be able to compare your creditworthiness like-for-like with records of other borrowers’ payment histories. Take-home pay for the same salary can vary widely, making comparisons difficult.
Step 2: Determine How Much You Pay Towards Debt Every Month
Now determine how much you spend in total on existing mortgage loans, auto loans, personal or student loans, as well as lines of credit and credit card minimum payments on a monthly basis. This total DTI needs to include all the debt payments you already make every month.
Step 3: Divide the Two Numbers Above
Debt (Step 2) ÷ Income (Step 1) = a decimal figure
Step 4: Multiply that Decimal Figure by 100
The resulting number is your debt payments to income ratio or DTI ratio.
DTI Ratio Example
Keyshawn has been working for a law firm for six years and is currently making $74,500 per year. Take a look at his calculations below:
Monthly Gross Income: $6,208
Take the yearly salary of $74,500 and divide it by 12. Remember, gross income is the amount you're paid before any deductions. Keyshawn's annual gross income of $74,500 works out at $6,208 per month, gross.
Monthly Debt Payments: $1,850
This includes:
- Mortgage: $1,000
- Student Loan: $400
- Auto Loan: $350
- Credit Card: $100
These are all the minimum payments required, not taking into account any extra payments he chooses to make. Keyshawn’s minimum total debt obligation per month is $1,850.
Keyshawn's DTI
Keyshawn’s DTI ratio is calculated by dividing the monthly debt payments by the monthly gross income and then multiplying by 100 to convert the decimal into a percentage:
| $1,850 ÷ $6,208 = .298 or 29.8% |
How to Lower Your DTI Ratio
Working to lower your total DTI before applying for a loan is a smart step. Here are four things you can do to bring your DTI under control.
- Pay more than the minimum: By accelerating payments on your loan you can lower your loan payments, directly affecting your DTI. Beware, however, of prepayment penalties for early pay-offs. At our credit union, we refuse to charge prepayment penalties. Instead, we want to celebrate with you if you pay off your loan early! 🎉
- Consider debt consolidation: By combining more debts together into a single credit card balance or personal loan, you can simplify payments and possibly lower your monthly required minimum.
- Reduce mortgage payments: If you are already paying off a mortgage, consider refinancing first. You might be able to access lower monthly payments that will reduce your DTI.
- Increase your income: Asking for a raise or starting a new job or side hustle can improve your gross income, lowering your total DTI. You might be able to find a few side hustle ideas with Amazon.
Financing Challenges With a High DTI
Even with good credit, a high DTI can complicate your financing choices. In particular, you could face:
- Higher interest rates: Lenders may charge higher rates to offset your risk.
- Application denials: Some lenders may outright deny your loan application.
- Less flexible terms: Approval might come with stricter terms and conditions.
- Need for mortgage insurance: You may be required to purchase mortgage insurance, adding to your financing costs.
- Limited loan options: Fewer lenders may be willing to offer you credit.
Saving on Financing By Making Extra Payments
Paying more than your minimum payment amount can lower your debt burden while saving you significant interest. 💳
For example, if you have a $5,000 credit card debt with a 20% interest rate and a minimum payment of $100 per month, it would take you over seven years to pay off the debt and cost you more than $5,000 in interest.
However, if you double your monthly payment to $200, you could pay off the debt in just over two years, saving you more than $3,000 in interest.
Use our Debt Payoff Calculator to see your savings potential and create a plan to pay off your debt faster.
Lower Your DTI by Reducing Debt
The best way to improve your DTI is of course to reduce or eliminate your debt. There are many ways to do this, including debt consolidation and refinancing, but one of the best is to simply prioritize payments of your highest-interest debts first.
For example, by focusing on credit card debt first and making extra payments while maintaining minimum payments on the other loans, you can pay off the credit card faster, reducing your debt, lowering your debt and limiting the overall interest paid. Once the credit card is paid off, you can redirect those payments towards the auto loan, and finally to the student loan.
Use ourGet Out Of DebtCoach to create a customized debt repayment plan that will work to lower your DTI over time.
Putting Better Credit Within Reach
Here, we’ve covered how your DTI ratio works and used examples to show why it is important. We’ve shown how reducing your debt load can put better financing within your reach and suggested concrete ways you can work to reduce what you owe. We’ve also provided links to our online tools to help you manage debt better.
For many of us looking to consolidate loans or reduce the impact of borrowing on our DTI, personal loans often offer an affordable and credit-friendly way to go.
At Copper State CU we’re dedicated to helping you reach your financial goals. We can help you manage your DTI with personal loans tailored to your needs. All of our personal loans include:
- Competitive rates
- Flexible repayment terms
- A quick application process
- No restrictions on use
Let us show you how you can make borrowing more affordable.
This article is intended to be a general resource only and is not intended to be nor does it constitute legal advice. Any recommendations are based on opinion only. Rates, terms and conditions are subject to change and may vary based on creditworthiness, qualifications, and collateral conditions. All loans subject to approval.