Debt-to-income ratio (DTI) is a personal finance metric that represents an individual’s debt payment to his or her overall income, expressed as a percentage.
In layman’s terms, debt-to-income ratio is a single number that predicts your ability to pay back the money you’ve borrowed. Lenders often use your debt-to-income ratio as a qualifier for taking out loans like a mortgage. But it’s also a useful way to check in on your own financial situation, as a high debt-to-income ratio may be a warning sign that you need to take a closer look at your finances.
In order to get a better understanding of what debt-to-income ratio represents and how it’s used, it’s best to first learn how it’s calculated.
Types of Debt-to-Income Ratios
There are two different types of debt-to-income ratios — back-end and front-end.
Back-end debt-to-income ratio — or more commonly known simply as debt-to-income ratio, defined above — gives a wider look at where you sit financially compared to the state of your debt.
Front-end debt-to-income ratio is a version of DTI that calculates how much of a person’s gross income is going toward housing costs. If someone has a mortgage, the front-end DTI ratio is calculated as housing expenses (mortgage payments, mortgage insurance, etc.) divided by gross income.
What Factors Make Up Debt-to-Income Ratio?
As the name suggests, one of the most important things you need to know in order to understand debt-to-income ratio is how much debt you have. Your total debt includes things like:
- Auto loans
- Student loans
- Personal loans
- Alimony, child support and other financial judgments
- Minimum credit card payments
How to Calculate Debt-to-Income Ratio
Whether you have debt or not, everyone has a debt-to-income ratio. Fortunately, as complex as it may sound, if you learned to divide in elementary school, you’ll be able to understand this simple concept! In fact, you probably already think about it to some extent every month when you plan out your budget.
The first step to budgeting — and calculating your debt-to-income ratio — is to figure out how much money will be coming in each month after taxes. That will be your gross monthly income. Then consider how much you will spend each month on debt payments.
Here’s a basic formula you can follow to calculate your debt-to-income ratio:
DTI = TOTAL MONTHLY DEBT PAYMENTS / GROSS MONTHLY INCOME
What Is a Good Debt-to-Income Ratio?
It’s hard to know what’s considered “good,” so knowing how to calculate your debt to income ratio doesn’t mean much until you have some context. Generally, the lower your debt-to-income ratio, the better, because it means you’re not spending a large portion of your income paying off debt. While it can be subjective on a lender by lender basis, a good debt-to-income ratio is typically anything smaller than 36 percent. If your debt-to-income ratio is more than 50 percent, you have too much debt and you’re spending at least half of your monthly income to pay for it.
Debt-to-Income Ratio for a Mortgage
If you’re looking to buy a house in the near future, you should calculate your debt-to-income ratio, because the maximum ratio that a prospective homebuyer can have is 43 percent. Anything above 43 is a sign to the lender that you may not make your payments and as a result are too risky to lend money to. There are some exceptions on either end, of course.
While 43 is the maximum, some conventional lenders would prefer to see a debt-to-income ratio closer to 36 percent. This would be a benefit to the prospective homebuyer as well because they may be able to get better loan terms as a result. Conversely, for Federal Housing Administration loans, lenders may be able to accept a DTI ratio as high as 50%.
Does Debt-to-Income Ratio Affect Credit Scores?
Your debt-to-income ratio does not directly affect your credit score. Credit agencies don’t have access to your income, meaning they have no way to know your debt-to-income ratio. They do, however, look at your credit utilization which is another metric of your overall financial health.
How to Improve Debt-to-Income Ratio
Maybe you’ve had some trouble buying a car or maybe you’d like to start thinking about buying a house in the near future. If you’re not satisfied with your debt-to-income ratio, there are two ways to improve it.
Option 1: Increase your income.
This may be easier said than done, but consider whether it’s feasible for you to take on some overtime, ask for a raise or maybe start a side hustle based on a hobby you have. Ideally, some form of passive income would be the best way to boost your monthly income without having to spend all of your free time working.
Option 2: Pay off your debt.
Your debt-to-income ratio is variable based on how much you’re paying toward debt each month. While you should be paying at least the minimum payment, you can pay more to pay the debt off faster. Your debt-to-income ratio may be higher in the short-term, but will eventually get back to an acceptable level once you’ve paid your debts. Consider options like debt consolidation if you’re having trouble managing your payments.
Consumer debt is growing at an alarming rate, meaning a high debt-to-income ratio, unfortunately, isn’t all too uncommon. Coming to terms with your debt is never easy, but continuing to recklessly accrue debt only makes it harder on you down the line. It’s never too late to improve your financial habits and turn your situation around. If you feel that you’re in need of credit repair or other financial services, contact credit advocates to start making a change.