If you’re thinking of getting a mortgage, car loan, credit card or another line of credit, you may have stumbled upon the term debt-to-income ratio, or DTI. DTI plays a significant role in determining whether you are going to be pre-approved for a loan or not. It’s an important ratio that shows lenders how your debt stacks up against your monthly income.
Here’s more information on what DTI is, how to calculate it and if it affects your credit.
What Is Debt-to-Income Ratio?
In simple terms, your debt-to-income, or DTI, ratio is the percentage of your monthly gross income that goes into settling your monthly debt payment. Banks, credit unions and other financial institutions use DTI to determine your ability to repay a loan.
Lenders prefer a low DTI ratio because it demonstrates that a borrower has a good balance between their income and debt. So, if you have a DTI ratio of 15%, it means that 15% of your monthly gross income covers your debts every month.
On the other hand, a higher DTI ratio means that a borrower’s monthly income might not be enough to settle their monthly debts.
A lower DTI ratio indicates you can probably pay your monthly debts with ease. Therefore, you won’t have trouble accessing new loans from banks, credit companies, and credit unions.
However, keep in mind the maximum DTI ratio varies depending on the lenders. While it’s true that a low DTI can help your chances of getting approved for a loan, there are personal loan providers that allow higher DTIs.
How to Calculate Debt-to-Income Ratio?
You can calculate your debt-to-income, or DTI, ratio by dividing your monthly debt payments by your gross income (before taxes and other deductions). Below are steps to help you calculate your DTI ratio:
- Sum up your monthly bills, including:
- Monthly house payment
- Student loans
- Monthly alimony or child support payments
- Monthly credit card payments
- Auto loan
- Monthly debt consolidation loan payments
Avoid counting recurring bills as part of your monthly payments since they represent fees for services, not accrued debt. These recurring payments include:
- Monthly utilities like gas, water and electricity
- Paid cable or streaming services
- Health insurance and other medical bills
- Childcare costs
- Cell phone services
- Dived the sum of your monthly debt payments by your monthly gross income from:
- Day job
- Side hustle
- Child support
- Disability income
- Investments (rental properties, stock dividends, etc.)
- Other income
- Multiply the results in decimal by 100 to get your DTI percentage
The lower the percentage of your DTI ratio, the better your chances with lenders when applying for credit.
What’s Considered a Good Debt-to-Income Ratio?
Most lenders consider individuals with a debt-to-income, or DTI, ratio of 36% and lower as less risky borrowers because their debts are manageable relative to their income.
A DTI ranging between 32% to 49% can help secure you a loan, but you should make some effort to help your ratio. If you have a DTI ratio of 50%, securing credit might prove difficult because you might not have additional money to save and spend each month. As a result, you might have a hard time paying off any new loan.
That said, your DTI ratio is a vital metric used by lenders and creditors to determine your borrowing risks. A lower DTI ratio, like 32%, shows that you can manage your loan payments effectively. Therefore, lenders are more likely to approve you for a new loan application.
Can Your Debt-to-Income Impact Your Credit?
Credit-reporting agencies do not include your income in your credit report. As a result, your debt-to-income, or DTI, ratio does not impact your credit report or credit scores. Nonetheless, lenders and creditors calculate your DTI ratio before deciding to offer you credit.
DTI is one indicator banks and credit unions consider when determining your ability to pay a loan. So, it’s wise to keep your card balance below your credit limit to avoid lowering your credit score.
And you should take advantage of a credit report monitoring services to keep an eye on your credit scores and work toward your credit goals.