Your debt-to-income ratio (DTI) is a calculation that shows how much debt you have compared to your income. It’s an indicator of your financial health and illustrates you’re spending beyond your means. The debt-to-income ratio is an important factor that lenders consider when approving credit or loans, such as a mortgage.
What is Your Debt-to-Income Ratio?
Debt-to-income is a side-by-side comparison of all of your monthly debt bills versus your monthly income. So, let’s say you have a monthly income of $5,000. If your monthly mortgage payment is $1,500, your car payment is $300, your car insurance is $150, and your student loan payment is $300, then your monthly debt payments add up to $2,250. Next, you take $2,250 and divide it by $5,000. Your debt-to-income ratio is 45%.
The official calculation is:
Debt to Income Ratio = Total Recurring Debt / Gross Monthly Income
Your debt-to-income ratio considers all the monthly payments you have to make. This can include:
- Payments on credit card balances
- Property tax
- Personal loans, payday loans, etc.
- Homeowner association fees
- Private mortgage insurance (PMI)
Why is Debt-to-Income Ratio Important?
Your debt-to-income ratio does not show up on your credit report or impact your credit score. Still, many lenders will calculate this ratio on their own when considering your application for credit. This is because your DTI ratio shows how much room you have to take on more debt and the likelihood that you will make payments. If you have a low DTI, you have a lot of income leftover every month to pay off debt. Conversely, a high DTI indicates that you’ll have trouble paying off additional new debt because you’re already paying off so much.
Most notably, mortgage lenders look at your debt-to-income ratio when approving your application for a mortgage.
What is a Good Debt-to-Income Ratio?
A “good” DTI will vary from lender to lender, but most mortgage lenders want to see a maximum ratio of 43%. Anything higher than 43% suggests that you’ll have trouble paying off your loans, and your mortgage application may be denied. After you pay off your debts, you still need to have money left over to cover the necessary costs of living, as well as some discretionary spending money.
It’s also important to understand that your future mortgage payment is included in the debt-to-income ratio. So, in the above example where the individual makes a gross monthly income of $5,000 – their future mortgage payment of $1,500 is included. Unfortunately, they are slightly over the magic 43% rule, so they would need to find a way to lower their debts slightly or raise their income slightly. Although note that the 43% rule isn’t set in stone, so the applicant might still be approved, it all depends on their lender.
If you’re applying for a mortgage and your DTI ratio is above 43%, it might be a sign that you’re considering properties that are above your budget. If this is the case, re-evaluate and find a new mortgage price that keeps you at a healthy debt-to-income ratio.
How to Fix Your Debt-to-Income Ratio
Before you apply for new credit or loans, such as a mortgage, do everything in your power to lower your debts. Look at your current DTI ratio and plan where you want to be.
Some of the steps you can take include:
- Make more than the minimum monthly payment on debts, so you pay them off faster
- Consolidating your debt into one payment with a lower interest rate
- Paying off smaller outstanding debts, such as credit card balances
- Getting a raise or a second job to increase your income
- Make a budget, so you can reduce spending and pay off some debts
- Avoid taking on more debt
You know your debt-to-income ratio matters to mortgage lenders. Before applying for a mortgage, calculate your DTI with your future mortgage payment included. If it’s not where it should be, take some time to lower your DTI before starting a mortgage application.