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What Is A Debt-To-Income Ratio? Why Is It Important?

by Refi.me Staff on October 13 2021

Debt-to-income (DTI) ratio is the percentage of your gross monthly income that goes towards your monthly debt payments. It compares how much of your earnings go towards paying off your debt against how much you earn every month. A low DTI means only a small portion of your income goes towards your debt.

Why Is It Debt-To-Income Ratio Important?

A debt-to-income ratio is a good indication of your ability to manage monthly payments and repay your debts. It is one of the metrics that lenders use to determine your borrowing risk.

A low DTI ratio demonstrates a good balance between income and debt. It indicates that you earn enough to pay off your debts and are not overextended. This makes you a low-risk borrower who’s less likely to default on your loan. You’ll find it easier to get approved for a loan with a low debt-to-income ratio.

On the other hand, a high DTI indicates a high amount of debt compared to the amount of income. This will limit your borrowing options. A high DTI could mean that you’re struggling financially and can’t afford to take on any more debt. This is a red flag for lenders. They are more likely to reject your loan application.

What Is A Good Debt-To-Income Ratio?

To assess your likelihood of getting approved for a loan you need to first know what is considered a good DTI ratio.

The truth is, this could vary from one lender to another. Every lender sets their own maximum DTI ratio, above which they won’t approve loan applications. The lower your DTI ratio, the better your chances of getting approved for credit cards and loans.

Lenders view anything lower than 35% as favorable. It means you have money remaining after paying off your monthly bills and can afford to take on more debt. If your DTI ratio is less than 35%, you’ll have no trouble at all getting approved.

Your DTI ratio is considered adequate if it is between 36% and 49%. You’ll get approved by fewer lenders. Many will require you to meet additional eligibility criteria.

In general, most lenders keep 50% as their cutoff for approval. Anything above that and you’ll get rejected right away. It indicates that you have limited money left after paying off your current debts. You’re more likely to default on your payments if you take on any more debt. Applicants with a high debt-to-income ratio are risky borrowers and most lenders prefer not to have to deal with it.

How To Calculate Your Debt-To-Income Ratio

DTI is calculated as Gross Monthly Income / Total of Monthly Debt Payments x 100

Use this step-by-step to calculate your debt-to-income ratio:

  1. Add up your monthly debt payments. This includes credit card payments, all loan payments, and mortgage payments, or monthly rent. Utilities, groceries, and taxes are not included in these payments.
  2. Add up your total income if you’re earnings are coming from multiple sources.
  3. Divide your total monthly debt payment amount by your gross monthly income. This is your income before taxes.
  4. You will get a result with a decimal. Multiplying the result by 100 will give you your debt-to-ratio percentage.

Is Your DTI Too High? Here’s What You Can Do To Lower It

You’ve seen how a high DTI can make it difficult for you to get a line of credit. Even if you do get approved, you’ll pay a higher interest rate. Taking steps to lower it can pay rich dividends when you apply for a loan or mortgage later. Not only will it increase your chances of getting approved, but you’ll also qualify for a lower interest rate. Even the smallest drop in the rate can save you a substantial amount over the life of your loan.

These are some things you can do to lower your debt-to-income ratio.

Track Your Spending

Most of us keep track of our large monthly expenses – rent or mortgage payments and utilities – but we ignore our smaller purchases. When tracking your spending, you’ll be surprised at how much they add up to at the end of the month. It’s those little things that sneak up on you and add up to a large total.

When you start tracking your credit card spending, you’ll become more mindful about what you’re spending on. Do this for a couple of months and you’ll start to see a pattern. You’ll also be able to identify where you’re spending money unnecessarily and where you can cut back. Simply cutting back on unnecessary expenses can help lower your credit card bills. This will lower your debt-to-income ratio.

Remember, those miscellaneous expenses for groceries and other luxuries are not factored into the DTI calculation. But your credit card bill is. That daily Starbucks breakfast that you charge to your credit card will impact your DTI at the end of the month.

Develop A Strategy To Reduce Your Overall Debt

If you have extra cash, consider paying off your loans early to reduce your total debt load. If you have multiple loans, you can adopt either the avalanche or snowball strategy to do this.

The avalanche method is more popular. It involves paying off your highest-interest debt first. Once you’ve finished paying off this debt, you tackle the loan with the second-highest interest. This strategy will save you the most money. It’s also the fastest way to lower your debt-to-income ratio.

The snowball method considers the total loan amount. It ignores the interest rates of individual loans. This strategy involves paying off your smallest debt first. When that debt is fully cleared, you start paying off the next smallest debt. This strategy works on the basis that you’re likely to feel motivated when you see your debts dwindling.

Regardless of which strategy you use, you’ll pay off those debts faster and lower your DTI faster too. As an added bonus, you’ll also save on the accrued interest with you clear your loan early.

Reduce Those Credit Card Bills

Credit card purchases may earn you points and rewards but they also increase your debt-to-income ratio. As we said earlier, it’s your credit card bill that impacts your DTI, not your miscellaneous expenses. If you need to lower your DTI in a hurry to get approved for a loan, stop using your credit card for all purchases. Pay cash instead.

Better still, don’t purchase the item if you don’t absolutely need it. You can use the money to pay off a high-interest loan and reduce your overall debt instead.

 

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