The Skinny on Debt-to-Income Ratios

Unless you’ve applied for a loan or other form of credit, you may not have heard the term Debt-to-Income Ratio. If you have heard this term during the credit approval process, you may not know what it is referring to. Here is some information that will help you not only understand what Debt-to-Income Ratio means, but also some helpful ways of managing your DTI.

What it isdebt to income

The easiest way to explain Debt-to-Income Ratios is that it is the amount you owe compared to the amount you earn. When a lender looks at your DTI, they are looking at the percentage of your monthly income that goes towards paying back existing debts. Debt-to-Income ratios are used in conjunction with credit reports to make loan decisions. Managing your debt-to-income ratio requires a future-centric approach. Work towards reducing the number of debts you have now so when it comes time to seek a loan your DTI will be in a lower percentile.

Debt reduction is a time-extensive process but following through with a plan will help improve your debt-to-income ratio. There are two methods typically used to reduce the number of accounts you have open and the amounts you owe on each.

The first is called Debt Snowball. This method suggests looking at your debts and pay extra, more than your minimum monthly payment, into the one with the lowest balance. Once that account is paid off, take the money you would have used to pay it and put it towards the next lowest balance. Continue this until you have eliminated all of your debt.

A second method, and the one that will save you money in the long run, is called Debt Avalanche. This method has you pay extra into the account with the highest interest rate. When that account is paid off, you move down the list and start working on the next highest rated account. Your debt-to-income ratio will benefit from either method, just develop a plan that works best for you and stick with it.

You could, and probably should, seek an enhancement in your monthly earnings. Do not waste your money on the lottery; they are based on chance. You want a more stable source of income. A second part-time job could be a good option to add hundreds of dollars to your monthly income. If you are in a low wage job, work towards getting a promotion. There might not be an opening today but always in motion is the future. One will become available and you need to be ready for it. Develop the skills your employer seeks in that position you want now so you are ready to step in when it does open up. Develop the skills now at your current employer for when a position with another becomes available; there is nothing that says you cannot change employers. (A word of caution: do not hop around from one employer to another too often; this could potentially affect your eligibility to receive a loan or other form of credit.) Either way, be patient and grow yourself. The additional income provided by a promotion or job change will help improve your DTI.

How it is calculated

Mathematically, add up all of your debt payments due for a month then divide that by your gross income for the same month. This will give you the percentage lenders look at to determine if you are eligible for a loan. If your debts for the month total $1500 (this would include your mortgage payment) and your same-month earnings equal $4000, you would have a DTI of 38%.Your DTI only takes into account the debts listed on your credit report. Lenders do not include utility bills (electricity, water, gas), expenses (groceries, gas, clothing), telephone and internet bills, or rent when determining DTI. They do not factor in taxes either.

The lower your debt-to-income ratio, the lower the risk you present to a lender; they are more likely to approve your request. There is not one single set of criteria that lenders use. They will each set their own standards. Certain industries have adopted a universal guideline, however. Mortgage lenders typically will not approve a debt-to-income ratio over 43% for a qualified mortgage.

Personal loan lenders are different than mortgage providers and will generally approve consumers with debt-to-income ratios of 50%. The loans they provide are much smaller than mortgages and easier to recover from should a borrower default on the loan.

In the market for a new vehicle? Car loan providers typically cap the debt-to-income ratio at 40%. If you need one for transportation purposes, or because you are experiencing an increase in the size of your family (congratulations!), then go for a sensible car or van. This will keep the price down as well as the monthly payments. If you are dying to have that muscle car, be prepared for a high payment, and an higher DTI.

Good ratio

What has been discussed are the percentages loan providers will typically stop looking at when making their decisions. So what is considered a good ratio? Generally, 20% or lower debt-to-income ratios are considered good. There is room for improvement but if your DTI falls into this category you are a financially healthy individual. You have few debts, or you have paid off your debts (again, congratulations!). Your monthly income is sufficient to maintain those accounts in good standing, and you are enjoying the benefits by having extra money available and being able to take on additional forms of credit should you need/want to.

If your DTI falls anywhere between 20% and 50%, start working on developing a debt reduction plan using one of the methods above. You will not necessarily be denied a loan but you will want to improve your chances by clearing up some of your current debt before taking on new ones. Anything over 50% DTI may want to seek professional credit counseling to help them with a plan to reducing their debt.