What does debt-to-income ration mean and why is it important?
What is debt to income ratio and why is it important?
Shopping around for a credit card or a loan? If so, you'll want to get familiar with your debt-to-income ratio, or DTI.
Financial institutions use debt-to-income ratio to find out how balanced your budget is and to assess your credit worthiness. Before extending you credit or issuing you a loan, lenders want to be comfortable that you're generating enough income to service all of your debts.
Keeping your ratio down makes you a better candidate for both revolving credit (such as credit cards) and non-revolving credit (like loans).
Here's how debt-to-income ratio works, and why monitoring and managing your ratio is a smart strategy for better money management.
How to calculate your debt-to-income ratio
- Add up your monthly debt payments (rent/mortgage payments, student loans, auto loans and your monthly minimum credit card payments).
- Find your gross monthly income (your monthly income before taxes).
- Debt-to-income ratio = your monthly debt payments divided by your gross monthly income.
Here's an example:
You pay $1,900 a month for your rent or mortgage, $400 for your car loan, $100 in student loans and $200 in credit card payments—bringing your total monthly debt to $2600.
Your gross monthly income is $5,500.
Your debt-to-income ratio is 2,600/5,500, or 47%.
What do lenders consider a good debt-to-income ratio?
A general rule of thumb is to keep your overall debt-to-income ratio at or below 43%. This is seen as a wise target because it's the maximum debt-to-income ratio at which you're eligible for a Qualified Mortgage —a type of home loan designed to be stable and borrower-friendly.
Debt-to-income ratio of 36% or less
With a DTI ratio of 36% or less, you probably have a healthy amount of income each month to put towards investments or savings. Most lenders will see you as a safe bet to afford monthly payments for a new loan or line of credit.
Debt-to-income ratio of 36% to 41%
DTIs between 36% and 41% suggest that you have manageable levels of debt in relation to your income. However, larger loans or loans with strict lenders may like to see you pay down some of this debt to reduce your DTI ratio before you earn their approval.
Debt-to-income ratio of 42% to 49%
DTIs between 42% and 49% suggest you're nearing unmanageable levels of debt relative to your income. Lenders might not be convinced that you will be able to meet payments for another line of credit.
Debt-to-income ratio of 50% or more
At DTI levels of 50% and higher, you could be seen as someone who struggles to regularly meet all debt obligations. Lenders might need to see you either reduce your debt or increase your income before they're comfortable providing you with a loan or line of credit.
Does your debt-to-income ratio affect your credit score?
The short answer is no. Credit reporting agencies don't collect consumers' wage data, so debt-to-income ratio won't appear on your credit report. Credit reporting agencies are more interested in your debt history than your income history.
Although your credit score isn't directly impacted by your debt-to-income ratio, lenders or credit issuers will likely request your income when you submit an application. Just as your credit score will be one factor in their application review process, your debt-to-income ratio will also be taken into account.
For this reason, maintaining a healthy debt-to-income ratio can be just as important for loan or credit eligibility as having a good credit score.
What happens if my debt-to-income ratio is too high?
If your debt-to-income ratio is higher than the widely accepted standard of 43%, your financial life can be affected in multiple ways—none of them positive:
- Less flexibility in your budget. If a significant portion of your income is going towards paying off debt, you have less left over to save, invest or spend.
- Limited eligibility for home loans. A debt-to-income ratio over 43% may prevent you from getting a Qualified Mortgage; possibly limiting you to approval for home loans that are more restrictive or expensive.
- Less favorable terms when you borrow or seek credit. If you have a high debt-to-income ratio, you will be seen as a more risky borrowing prospect. When lenders approve loans or credit for risky borrowers, they may assign higher interest rates, steeper penalties for missed or late payments, and stricter terms.
Why your debt-to-income ratio matters
Keeping your DTI ratio at a reasonable level signals that you're a responsible manager of your debt, which can improve your eligibility for financial products.
The DTI ratio also provides you with a good snapshot of your current financial health. If it's below 35%, you're in a good position to take on new debt and pay it off with regularity. But when it's over 50%, you should try to reduce the number of debt obligations (by either working to pay off credit cards, find a more affordable home, or refinancing your current loans) or find ways to generate more income. When your DTI falls between 35% and 50%, you'll usually be eligible for some approvals. Even so, your financing terms on lines of credit will be better if you hit the premium level of sub-35% debt-to-income.