What is debt-to-income ratio?
Mortgage lenders use debt-to-income ratios to assess their borrowers’ creditworthiness. A “good” DTI is generally agreed to be below 43%, though some lenders may want yours to fall below 36%. A high DTI can be a red flag that signals that you’ll struggle to manage additional household debt, which can elevate your risk in the eyes of lenders.
How is DTI calculated?
Your DTI is simply the amount of monthly debt you owe divided by your total monthly income. Of course, properly calculating your debt-to-income ratio means first determining those two numbers.
First, you can use your pay stubs or direct deposits to determine your gross (pre-tax) monthly income. If you’re unsure, you can simply use the adjusted gross income from your last tax return and divide that number by 12.
Next, you’ll add up all your total monthly debt payments. These include things like:
- Auto loans
- Student loans
- Personal loans
- Credit cards
Adding all your monthly loan payments together will get you the total recurring debt. Once you have both numbers, you’ll calculate your DTI by dividing your total monthly debt by your gross income.
For instance, if your total monthly debts add up to $2,100, and your monthly income is $5,000, your debt-to-income ratio will be 42% ($2,100 / $5,000).
Using a debt-to-income ratio calculator
Take advantage of a free DTI calculator. Using these calculators involves the same process outlined above. You’ll enter your income and recurring monthly debts into the calculator, which will then provide your DTI as a percentage.
One advantage of electronically calculating your DTI is that you can see how paying down certain debts (such as your credit cards) will affect it. That can prove valuable in strategically paying down your debts prior to applying for a home or auto loan.
What factors make up a DTI?
Lenders will often take a deeper dive into your debt-to-income ratio by splitting it up into two key components known as your front-end ratio and back-end ratio.
Here’s how each one works and how it impacts your creditworthiness:
Front-end ratio
Your front-end ratio is also known as your “housing ratio,” as it primarily focuses on housing-related costs, such as:
- Monthly mortgage payments
- Rent payments
- Property taxes
- Homeowners insurance
- Homeowners Association (HOA) dues
Lenders tend to prefer that your front-end DTI remains below 28%.
Back-end ratio
Of the two components of DTIs, lenders may be more interested in your back-end ratio calculation because of its larger scope. While your front-end ratio focuses on housing expenses, your back-end ratio involves a broader look at your overall finances.
It will include all of your monthly expenses, ranging from credit card payments to student loans to other forms of monthly expenses. As a result, it will provide a more comprehensive picture of your current financial standing.
Most lenders expect a back-end ratio of no more than 43%, though depending on the type of loan, a lender may work with you even if yours is closer to 50%.
Will my debt-to-income ratio impact my credit?
On its own, your debt-to-income ratio will not directly impact your credit score, in part because consumer credit bureaus do not measure your monthly income. However, the factors that contribute to your DTI may impact your credit.
For example, your credit score is partly influenced by your credit utilization ratio, which is the percentage of your credit limit that you currently use. Therefore, high monthly credit card payments can raise your DTI and show that you’re using a larger portion of your credit limit, which can lower your credit score. Conversely, paying down your credit card debts can lower both your DTI as well as improve your credit score.
How to lower your DTI
By now, you have all the resources you need to calculate your DTI. But what can you do if your DTI is a little higher than you anticipated?
First, don’t panic: Having a high debt-to-income ratio won’t necessarily prohibit you from securing a home or auto loan. But you may find yourself strapped with higher interest rates than if your DTI was more favorable.
Thankfully, there are some basic steps you can take to lower your monthly debts and raise your monthly income, improving your debt-to-income ratio in the long run:
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Pay off debts
The surest way to lower your DTI is to pay off your monthly debts as soon as possible. One strategy to do so is known as the “snowball method.” Pay off your smallest debt first, then tackle the next smallest, and so on.
Paying off short-term debts, such as credit cards, can be a particularly valuable way to lower your DTI, and you can often do it faster than paying off student loans or car loans. Make more than the minimum payment each month to get out of debt faster and avoid additional interest charges.
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Refinance major debts
It may be possible to lower your monthly debts by refinancing larger loans like student and car loans. In doing so, you’ll receive a new loan with a smaller monthly payment, which can lower your DTI.
Just be careful, though, as lowering your monthly payments might mean you’re taking on a longer loan term. And that means you’ll be paying more in interest over the lifespan of the loan. Make sure to weigh the benefits of a smaller DTI with the additional interest you’re taking on.
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Consolidate debt
Debt consolidation programs will allow you to bundle your debts into one simple loan, typically with a smaller payment. For instance, some credit card issuers will offer a balance transfer card with a promotional rate of 0% APR for one year. If you can transfer your loan balance(s) to one of these cards, you may be able to get out of your debt without any additional interest if you pay it off within the promotional period.
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Cut down on monthly expenses
While things like groceries, streaming subscriptions, and dining out won’t directly impact your DTI, cutting back on household expenses will free up more money that you can allocate toward your debt. Additionally, cutting back on luxury purchases will mean putting even less money on your credit card, thereby preventing you from taking on additional debt.
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Take on a “side hustle”
Taking on a second job may sound extreme, but if you’re applying for a major loan, it may be worth it. A side job will increase the amount of monthly income you receive, which will help to offset the amount of debt you carry. At the same time, you’ll have more income to allocate to your debts, which can also lower your DTI.
If time is an issue, consider pursuing raises and promotions at your current job, which will help you raise your household income.
DTI Ratio and the Mortgage Process
Understanding your debt-to-income ratio will better equip you for the mortgage process. If you have additional questions about the optimal DTI for your mortgage program, talk to a real estate professional. Learning to manage your debts will improve your chances of securing favorable loan terms, which can save you thousands over the course of your loan.
