How to Calculate Debt-to-Income Ratio
9 MIN READ
Published April 07, 2023 | Updated October 02, 2023
A lot of borrowers are taken by surprise when they realize their high debt-to-income (DTI) ratio is the reason they get turned down by lenders. But don’t despair. It is possible to work your way toward an ideal DTI.
Your debt-to-income or DTI ratio is the total monthly debt payments divided by the total gross income per month.
This ratio helps lenders determine which borrowers will be able to make monthly payments. The lower your DTI ratio, the more you will be seen as a reliable borrower.
If you are planning to apply for a loan, it is important to get a deep understanding of what a debt-to-income ratio is, how it is calculated, and what you can do to improve your chances of qualifying.
What Is a Debt-to-Income Ratio?
A debt-to-income ratio determines how much of your monthly income goes towards making debt payments. This figure is used by lenders to determine if you can afford monthly payments on a new home loan, auto loan, or personal loan.
The front-end ratio is calculated as your housing expenses, such as mortgage, property taxes, and homeowners insurance, divided by your gross income.
The back-end ratio takes into consideration all other types of loans, such as car loans and credit cards.
The maximum DTI ratio a lender is comfortable with will vary. The general guideline is that the lower your debt-to-income ratio, the higher your chances of getting approved for the loan.
What Is an Ideal Debt-to-Income Ratio?
There is no one right answer when it comes to the ideal DTI ratio. It depends on a number of factors, such as your job stability, income, goals, and lifestyle.
Generally, 43% is the maximum DTI ratio you can have and still get qualified for a loan. Mortgage lenders prefer borrowers to have less than 36% DTI.
Debt going towards paying your rent or mortgage payment should not be more than 28% of your gross income. For example, if your gross income is $5,000 per month, the maximum amount of mortgage payments at 28% would be $1,400 ($5,000 x 0.28= $1,400).
Here are a few guidelines for different debt-to-income ratios and what they mean:
A DTI of up to 35% is considered healthy as it reflects your ability to repay debts. This means that if you were to take on new debt, you’ll find the monthly payments manageable and may still have money left for savings.
DTI ratios in this range may mean that you are currently managing your debt well, but if your situation changes, you may be at risk. You may still qualify for a new loan, but there wouldn’t be a lot of wiggle room in your budget.
With a debt-to-income ratio in this range, you may not be able to qualify for a mortgage but will still qualify for smaller personal loans. This is the time to improve your ratio by enrolling in debt relief program to strengthen your credit profile.
A DTI ratio of above 50% is considered unhealthy. This is a sign that you need to reduce your debt obligations quickly. This is a good time to explore options like debt consolidation or credit counseling.
What Contributes to a Debt-to-Income Ratio?
The two most important factors impacting your debt-to-income ratio are your income and debts. To earn a good debt-to-income ratio, your income and debt levels should both be at a healthy level.
If there’s no way for you to increase your income now, focus on debt reduction strategies to get out of credit card debt or other financial burdens.
If you have a high DTI, you may still be able to get a loan but at higher interest rates.
Lowering your DTI has many benefits. It will give you more loan options to choose from and help you access lower interest rates. You’ll have to work on improving both areas to lower your DTI before qualifying for a loan.
How to Calculate Debt-to-Income Ratio
Your DTI can be calculated with a simple debt-to-income formula. Follow these three steps:
- Make a list of all your monthly bills. Add your rent payment or mortgage, credit card payments, student loan payments, alimony, child support, and car payments. Groceries, medical costs, and utilities are not included.
- Divide your debt payments by your monthly gross income. This is the income before deductions and taxes.
- Multiply this number by 100 to get a percentage.
A Quick Example of a DTI Calculation
Let’s say your total monthly debt payment is $2,500, and your gross monthly income is $6,000. You can calculate your debt-to-income ratio by dividing your debts ($2,500) by your gross income ($6,000).
The resulting number (0.4) can be multiplied by 100 to get your DTI of 40%. This DTI shows that 40% of your gross income goes towards paying your debts each month.
Does Debt-to-Income Impact Credit Score?
Yes. your debt-to-income ratio impacts your credit utilization ratio and also affects your credit score. The credit utilization ratio is the amount of credit you are using compared to your available credit limit. This accounts for 30% of your FICO score.
When you reduce your total debt through debt solutions like debt management, it lowers your DTI and your credit utilization. This, in turn, improves your credit report.
7 Tips to Lower Your Debt-to-Income Ratio
With a low DTI, you can enjoy lower interest rates and get access to more credit options. Here are a few tips on how to achieve that:
1. Find Ways to Increase Income at Your Job
Check with your employer to see if you can get overtime hours at work, which are typically paid at an extra 50% of your hourly rate. You can also negotiate with your current employer for a raise.
Either of these options can upgrade your income significantly.
2. Get a Second Job
Find a second part-time job to increase your income. You can also try to find a higher-paying job in your industry.
Apply for jobs at as many places as you can and compare offers you receive to see which one offers you the most boost in income.
3. Start a Side Hustle
Another great way to increase your income is by starting a side hustle or a side business.
Although side hustles may not make you rich, they can provide you with extra income that you can use to pay off your debts faster.
4. Pay Off Existing Debts
Use any extra cash you have towards paying your loans and credit cards to get rid of debt faster.
If you are making minimum credit card payments, focus on debt repayment strategies like debt snowball or debt avalanche. With the debt snowball method, you’ll start by paying off your smallest debt balance. Once that is paid off, you can move on to the next. With debt avalanche, you can start by paying off the debt with the highest interest rate before moving on to the next debt. This will allow you to pay off credit card balances faster.
If you have a lot of debt, you may want to consider debt settlement or other debt relief measures. This will also improve your credit history.
5. Reduce Your Expenses
Review your spending to find areas where you can save. Consider cutting subscriptions, avoiding dining out, or eliminating memberships that you don’t use. Use that extra money towards loan payments.
6. Increase Loan Term
You can also negotiate with your lenders to increase your repayment term. This can lower your monthly debt payments and your DTI.
A longer-term means you’ll be more likely to pay more in total interest over the loan term, so choose this option cautiously.
7. Avoid Additional Debt
Avoid getting a new credit card or loan. This will only add to your current debt payments and make the situation worse.
Once you make progress in reducing your DTI, be diligent and avoid taking on any more debt unless it's an emergency. Be sure to learn more about the importance of money management, as it will be vital in avoiding additional debt.
Your debt-to-income ratio can impact your eligibility to get a loan. Before applying for a new loan, try the tips listed above to lower your DTI and improve your financial health.
TurboDebt can help you lower your DTI by providing you access to debt relief options that can reduce your overall debt. Our consultations, counseling, and strategic planning services are designed to help you achieve your dream of a debt-free life.