Of the three key numbers that determine your financial health—verified income, credit score, and debt-to-income ratio—debt-to-income ratio (DTI) is probably the least commonly discussed. Nonetheless, it’s a key indicator of whether you’re living within your means, and something you should consider before applying for a loan. Turbo can help you determine your debt-to-income ratio, but if you want to understand how that number is calculated or how to lower yours, read on.
What is Debt-to-Income Ratio?
Debt to income ratio is simply the ratio of your total monthly debt payments to your monthly income. Lenders are interested in this number because it signals to them how likely you will be able to repay a loan. For example, a low DTI indicates that you make a fair amount more than you owe, meaning you’re a great candidate to loan money to. Inversely, if you have a high DTI, lenders may feel less inclined to grant you a loan.
What is Debt-To-Income Ratio Used For?
Debt-to-income ratio is a measure of risk expressed in a percentage that is primarily used by lenders to determine if you qualify for a loan. DTI is most closely associated with buying a home because in order to get a qualified mortgage you must have a DTI lower than 43 percent.
How to Calculate Debt-to-Income Ratio
To calculate your debt-to-income ratio, first, add up all your monthly debt payments. That includes your rent or mortgage, student loan and auto payments, alimony or child support, minimum credit card payment, and any other recurring payments. Next, divide this amount by your monthly gross income—your income before taxes. Multiply the resulting number by 100 to get your DTI percentage.
Follow this simple equation: (total monthly debt payments ➗monthly gross income) ✕ 100 = DTI%
Let’s say you pay $800 a month on rent, have a monthly student loan payment of $350, owe a minimum of $50 on your credit card, and have no other debt. Your total monthly debt payment is $1,200. If your gross monthly income is $4,000, your DTI is 30 percent.
What is a Good Debt-to-Income-Ratio?
The lower your debt-to-income ratio the less risky you are to lenders. If you’re wondering how your DTI looks to potential lenders, a DTI below 20 percent is considered especially low while a DTI above 40 percent makes you a potential risk according to the Federal Reserve. 43 percent is the highest DTI that mortgage lenders will accept, but don’t worry, you can lower your DTI if you’re considering taking out a loan anytime soon.
How to Lower Your Debt-To-Income Ratio
If your DTI is above that 40 percent threshold, you may want to consider a debt repayment strategy to start paying down your debt. Strategically paying your debt either in order of least to greatest owed or smallest to largest interest rate may help you stay on track and prevent you from sliding further into debt. In doing so, you’ll lower your monthly debt payments which will, in turn, lower your DTI percentage. Generally paying larger monthly payments and avoiding taking on any more debt will help you get there. There’s no harm in checking your DTI regularly if you feel you’ve made progress towards your goal. Celebrate the little milestones along the way!
As with any money management strategy, it always helps to be proactive. Familiarizing yourself with important financial numbers like debt-to-income ratio will help you understand what potential lenders are looking for, even if you’re not considering a loan in the immediate future. Doing so will help you get ahead of any mistakes you could be making along the way and may increase your chances of getting approved for a mortgage when the time comes.