What is a debt-to-income ratio?
A debt-to-income ratio is a tool lenders use to determine whether they believe you can manage additional debt.
A lower DTI ratio shows lenders you have sufficient income to balance your debt payments. Generally, with a lower percentage, you can expect to be approved faster and at better interest rates for any loans, lines of credit or credit card applications you make.
What lenders think when they look at a high DTI percentage is that it indicates you may have taken on too much debt for the amount of income you bring in. Most lenders would hesitate to lend you more money, making the assumption that you may not be able to actually consistently make an additional payment.
Is my DTI tied to my credit score?
No. Credit agencies don’t have access to any information about your income so they don’t have the figures to run the comparison.
Instead, your credit score is based on five factors, but primarily your payment history and your credit utilization.
But your DTI and credit score may still be linked in some ways. Let’s say you carry a lot of debt but have a long and consistent payment history. Payment history counts for about 35% of your credit score, so that looks positive for your score.
However, credit utilization makes up another third of your score.
Credit utilization is the measurement of how much of the credit you’ve used that is available to you. So if you have a credit card that has a limit of $10,000 and you currently have a balance of $7,500 on it, you’re utilizing 75% of your credit.
When you have a higher credit utilization, you’ll generally have a lower credit score. And carrying more debt on your credit card will also increase your DTI, regardless of your total income.
So while they’re not explicitly linked, both your credit score and DTI can be influenced by the same personal financial details.
What factors influence the average debt-to-income ratio?
Digging down further, there are two sets of ratios lenders consider when analyzing your DTI ratio. One looks at the front-end of your debt, while the other examines the back-end.
The front-end ratio is also sometimes known as the housing ratio. This shows what percentage of your monthly income goes towards your housing expenses, which includes your monthly mortgage payment as well as any property taxes, homeowners association fees and homeowners insurance.
Conversely, the back-end ratio deals with all your other monthly debts. Think your student loans, auto loan, credit card bills, child support or alimony and any other revolving type of debt you pay on a regular basis..
How to calculate debt-to-income ratio
To calculate your debt-to-income ratio, you’ll need to pull together all your monthly debt statements. Add up everything you regularly make payments on: your mortgage, auto loans, student loans, child support or alimony as well as your credit card payments.
That number is your total monthly debt payments. Then, take your debt payments and divide the figure by your gross monthly income (how much money you earn each month before taxes and deductions are subtracted).
Let’s do an example.Let’s say your mortgage requires a $1,400 monthly payment, you owe $350 on your car loan and then between your two credit cards, you pay another $250 every month.
- $1,400 + $350 + $250 = $2,000 *
Now let’s say your gross income for the month is $5,500.
- $2,000 / $5,500 = 36% *
In this scenario, your DTI is 36%. But if your gross income was less, the ratio would be higher. Even $500 less would bump the ratio up to 40% ($2,000 / $5,000 = 40%).
Debt-to-income ratio for mortgage applications
When you’re applying for a home loan, your DTI will be one of the most important factors mortgage lenders will consider, along with:
- Your credit score.
- Your savings.
- Your income.
- How much you're willing to pay as a down payment.
Looking at all these factors, a mortgage lender will come up with a number of how much they believe you can afford to take on in a mortgage loan.
Your DTI carries a lot of weight, but if you have plenty of savings or a sufficiently large income to balance it out, lenders may be willing to look past it.
The best way to ensure you not only receive approval for a mortgage application, but are able to lock down the lowest possible interest rate is to think about the full picture of your financial situation. That includes lowering your DTI, but also polishing up your credit and contributing consistently to your savings account.
What is the debt-to-income ratio to qualify for a mortgage?
The ideal debt-to-income ratio when you are hoping to qualify for a mortgage is 36%, according to the Consumer Protection Finance Bureau (CPFB).
Some lenders will approve you for a loan with up to 43%, but any higher than that would be pretty difficult to find a lender willing to lend you the funds.
However, most borrowers find when they apply for a loan that they’re generally granted approval for a larger loan than is responsible for them to take on.
So how do you know what the right amount is for you? Calculating your DTI for yourself can be a useful tool here to figure that out.
A good rule of thumb, according to the CPFB, is to ensure your mortgage debt doesn’t account for more than 28% to 35% of your income.
But again, in total, keep all your debt (including your mortgage payment) to no more than 36% of your income. So if you have plenty of other regular debts, factor that in first and see what’s left of that 36% to put towards housing expenses.
DTI and other types of credit
Lenders use your DTI as a tool for considering you for all types of loan applications — not just mortgages.
And even once you’ve qualified for a mortgage loan, if you want to refinance at any point or take out a home equity loan or home equity line of credit (HELOC), your current DTI will factor large in what you qualify for and at what interest rate.
Lowering your DTI is the best way to ensure you can access loans when you need a fast infusion of cash or that you won’t end up paying significantly more in interest.
So how do you do that? There are a few ways:
- Consolidate any debt you can. Sometimes all you need to do to rid yourself of debt is lock in a lower interest rate.
- Increase your income. You might not even have to take on another job to make a little more money.
- Avoid taking on any more debt. When you’re trying to lower your DTI, adding another loan, more credit card debt or new, more expensive auto loan payments to your records would be extremely unhelpful.
- Get a full picture of where your money is going and make a budget. The CPFB has some helpful resources for this.