What is your debt-to-income ratio?
Your debt-to-income ratio - also commonly shortened to DTI - is a measure of your monthly income vs. your monthly debt, with the resulting score used to determine how well you’re currently managing your debts and whether you have capacity to take on any more. Lenders will use your debt-to-income ratio as part of their affordability criteria when deciding whether or not to offer you a new mortgage (opens in new tab), loan or credit card; typically speaking, the lower your score, the more attractive you’ll be to lenders, as it indicates you’re comfortable with your current level of debt and would be able to afford another repayment if it were added into your monthly outgoings. Conversely, a high debt-to-income ratio indicates that you’re already spending a lot of your income on repayments, and as such might struggle taking on any more debt. As a result, lenders will view you as a far riskier prospect.
How your debt-to-income ratio is calculated
Your debt-to-income ratio is calculated by dividing your monthly debts (including everything from personal loan (opens in new tab), credit card, student loan and mortgage repayments to child support and alimony) by your gross monthly income, with the resulting figure expressed as a percentage. So for example, if your debt payments total $2,000 each month and your gross monthly income is $6,500, your DTI ratio would be 31% (2,000/6,500 = 0.307). Within this, however, lenders may look closer and consider your front-end and back-end debt-to-income ratio. The front-end debt-to-income refers to the percentage of your gross income that goes purely on housing costs (rent or mortgage payments, property taxes, etc.), while your back-end debt-to-income incorporates all other expenses PLUS your housing costs.
What is a good debt-to-income ratio?
Lenders all have different definitions of what constitutes an “ideal” debt-to-income ratio, but all agree that a lower score is preferable. Anything above 50% would be considered particularly risky; if more than 50% of your gross income goes on recurring credit obligations, you’ve got little left over to spend, save or cope with unforeseen emergencies, let alone cope with another debt. This means your credit options could be incredibly limited, and if they’re available, could be at a far higher rate. Most lenders typically prefer to see DTI ratios of 36% or less.
Debt-to-income ratio for a mortgage
Your debt-to-income ratio will be a key factor in mortgage affordability calculations, and the rule of “the lower the better” rings ever true in this sector. Typically speaking, borrowers will be required to have a front-end DTI ratio of 28% or below and a back-end ratio that’s no more than 43%, and in many cases, below 36%. The exception to this is with borrowers who have a high credit score together with savings and/or additional sources of income, in which case the maximum debt-to-income could be as high as 50%. However, it’s important to remember that none of these calculations take into account things like groceries, utilities, childcare costs or insurance premiums, which should always form part of your own decision-making process when determining if you can afford a new credit commitment. This is particularly the case when it comes to mortgages, the repayments of which are likely to take a significant chunk of your outgoings, and makes working out what mortgage you can afford (opens in new tab) an absolute must.
Debt-to-income ratio for personal or auto loan
The debt-to-income requirements are slightly different for personal and auto loans (opens in new tab), and in many cases, lenders will only be concerned with your ratio if your credit score dips below their threshold. However, if that’s the case, their criteria is often stricter, and the maximum ratio they’ll accept is likely to be lower than with a mortgage.
Does your debt-to-income ratio affect your credit score?
No. Credit bureaus don’t assess your income when determining your credit score, so in this sense, your debt-to-income ratio will have little bearing on your actual rating. That said, your overall debt is factored in, and it’s also often the case that someone with a high DTI ratio will have a higher credit utilization ratio. Representing the outstanding balance on your credit accounts in relation to the maximum amount of credit that is available to you, credit utilization can have a significant impact on your credit rating, and if it is high could indicate potential difficulties in managing the debt. If this is the case, it may be worth consolidating your debts in one loan, or credit repair services (opens in new tab) to look for ways to boost your score.
How can you improve your debt-to-income ratio?
The best way to improve your debt-to-income ratio – unless you can increase your income – is to pay down your debt. This will not only reduce your repayments and free up some monthly income, but it’ll lower your debt-to-income score, making you a more attractive prospect to lenders should you need to seek further credit or refinance mortgage (opens in new tab) options in the future. The first thing you should do is set out a plan, mapping out your current debts so you know where you stand. You could try and reduce any unnecessary spending, too, in order to see if you can free up any disposable income that could be put towards debt repayment. You may also need to choose between paying off your highest interest or smallest debts first (opens in new tab), depending on your particular debt profile and personal motivations – some like to pay off smaller balances first to keep them motivated, while others focus on paying down the account with the highest interest rate. Bringing what you owe together in one place using debt consolidation (opens in new tab) could be another option, while transferring credit card debts onto a balance transfer card or seeking a personal loan with a lower interest rate could also potentially lead to lower repayments. Ultimately, anything you can do to start reducing your credit balances can make a difference, lowering your debt-to-income ratio and improving your standing in the eyes of lenders in the process.
