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What is a good debt-to-income ratio, and how to improve yours?

Debt-to-income (DTI) ratio might not be a familiar term. However, it’s an important measure of risk when applying for loans, so it’s definitely something to know about. 

DTI ratio is the percentage of a person’s monthly gross income that goes to paying their monthly debt payments. 

When applying for a loan, lenders take several factors into consideration before approving a borrower. They’ll review your credit habits (e.i: Do you pay your bills on time?), as well as your income and current debt load.

The goal is to determine financial stability, and your DTI ratio is a good indicator of this.

Lenders will look at your DTI when you apply for a mortgage, an auto loan, and other types of loans. For a mortgage, lenders calculate your front-end DTI (the proportion of your gross income that goes to housing), and your back-end DTI (the proportion of “all” monthly debts relative to your income). 

A high DTI ratio makes a lender nervous because you “might” be unable to fulfill your financial obligations.

How to Calculate Debt-to-Income (DTI) Ratio?

Calculating your debt-to-income ratio is simple, and you only need two numbers.

To get started, add up all your monthly minimum debt payments. This can include house payments (mortgage), student loans, auto loans, credit cards, etc. 

Since you’re ONLY using debt payments for this calculation, don’t include expenses like groceries and utilities. 

Next, divide your total minimum debt payments by your gross monthly income. This figure IS your DTI ratio. So if your monthly debt payments are $3,000 a month, and your gross monthly income is $8,000 (3,000/8,000), you have a DTI ratio of 37%.

What Is a Good Debt-to-Income Ratio?

When applying for a mortgage, lenders prefer a front-end ratio of no more than 28% to 31% for a conventional and FHA loan, respectively. 

For your back-end ratio, ideally this shouldn’t exceed 36%, although some lenders allow a ratio as high as 43% to 50%. This is often the case when borrowers have compensating factors, such as a high credit score and large cash reserve.

A lower DTI ratio often indicates sufficient income to take on additional debt. On the other hand, a high debt-to-income ratio often indicates living beyond your means, thus increasing the risk of default.

How to Improve Your Debt-to-Income Ratio?

The good news is that you can improve your ratio. This takes careful planning, however, which starts with avoiding additional debt and coming up with a strategy to pay down existing balances. 

Sometimes, credit card payments push a person’s debt-to-income ratio too high. If this is the case for you, make extra payments on your cards. Reduce your day-to-day expenses, and then allocate extra money to debt repayment.  

Also, don’t make big purchases with credit unless you’re able to immediately pay off the balance.

Getting rid of loans can also improve your DTI ratio. Therefore, you might accelerate a car loan to pay it off sooner, or purchase a car with a cheaper monthly payment (if you can’t pay in cash).

Increasing your monthly income also improves your debt-to-income ratio, and creates additional income for debt repayment. Think of different ways to boost your monthly income. You can get a part-time job, freelance, start a side business, ask for a raise, or look for a new job.

The bottom line is that a high debt-to-income ratio can make it harder get approved for loans; and the more debt you have, the harder it is to save money.  

– Guest post by Erica Williams