For many Americans, the debt-to-income (DTI) ratio has a significant impact on their financial freedom. Everything from credit card offers, mortgage rates, auto loan eligibility, and credit card limits is impacted by your current DTI. While many other factors determine the kind of offers you receive from banks, debt-to-income ratio is one of the most important to control.
How to Calculate Your Debt-to-Income Ratio
As the name implies, debt-to-income ratio is determined by figuring out total monthly payments on debts and dividing them by monthly gross income. The result of this division is the percentage of incoming money that must be used to finance your current debt. It’s important to note that DTI is not directly influenced by the total amount of debt that you have but instead just the monthly minimum payments on that debt.
Add Up Expenses
The expenses to consider in DTI are a combination of credit card debt, loan debt, and recurring payments. To get an idea of a sample DTI, the following numbers will be used. The hypothetical sample is Sam, who owns a home and a rental property, both of which are under a mortgage. Sam has moderate credit card usage on two cards, is still paying student loans, has one personal loan related to a vacation, and is making payments on her car.
- Credit Card #1 Minimum Monthly Payment: $50
- Credit Card #2 Minimum Monthly Payment: $75
- Primary Mortgage Payment, Including Escrow: $1200
- Rental Mortgage Payment, Including Escrow: $1000
- Car Loan Payment: $300
- Student Loan Payments: $280
- Personal Loan Payment: $150
- Total Monthly Expenses: $3055
Calculate Your Gross Monthly Income
Gross monthly income is derived by taking all taxable sources of income and summing them together. This includes regular employment (either salaried or hourly), freelance work, child support payments, annuities, Social Security, and rental income. For our sample DTI, the following numbers will be used for income. Sam has a job that pays $60k per year, does side work that pays approximately $9k per year, and then rents out her rental property in full.
- Primary Job Monthly Gross Income: $5000
- Freelance Work Estimated Monthly Income: $750
- Rental Income: $1600
- Total Gross Monthly Income: $7350
Run the Numbers
To determine DTI, simply divide the total monthly expenses by the gross monthly income. Note that this number may be more generous in reality than your actual obligations and income, as the expenses don’t include common payments such as utilities. Similarly, the gross monthly income does not reflect mandatory obligations that may be deducted from your pay, such as taxes and health insurance premiums.
The best way to determine DTI is using the following equation: Expenses / Income = DTI
In the sample DTI, Sam has total monthly expenses of $3055 and a total gross monthly income of $7350. To find Sam’s DTI, plug the terms into the equation: $3055 / $7350 = 41.6%. Now that Sam’s DTI is defined, it can be looked at in terms of what it means for Sam’s future, whether this amount is good, excessive, or somewhere in the middle.
What Is a Good DTI?
Everyone carries some mandatory expenses, so each person has some kind of DTI. As a result, banks tolerate some significant amounts of DTI, but past a certain point, DTIs negatively impact your ability to secure new loans or favorable credit terms.
Generally, DTI up to about 35% is considered reasonable, and banks would not have problems opening up new unsecured loans or credit cards. More than 35% up to about 40-42%, banks would start to have concerns. This amount of debt is still manageable, but adding additional lines of credit with additional monthly payments would give potential lenders second thoughts unless your credit is otherwise very good.
In the 42-50% range, potential lenders would have significant concerns regarding the ability to repay debts. It’s still possible to secure loans or credit cards, but the odds are significantly reduced, and the terms will be much less favorable. If you’re already in this range, you will want to aggressively pursue methods to lower your DTI. For DTI of more than 50%, a repayment strategy may no longer be a realistic option, so more drastic solutions such as bankruptcy may be necessary.
Ways to Lower Debt-to-Income Ratio
Lowering DTI has many advantages, including the immediate one of having more liquid spending cash each month for investments, travel, and purchases. Much of the advice given for managing and reducing debt is also the same for reducing DTI, but the debt-to-income ratio can also be managed by debt consolidation. The following methods are the most effective at improving DTI:
- Pay off debt: Whether it’s a credit card or personal loan, completing the full payment schedule or eliminating the balance will remove this expense from your monthly expenses, improving your DTI.
- Paying off debt incrementally by making more than minimum payments is a key way in reducing debt while keeping funds available in case of emergencies and for living expenses.
- Large payments to pay off debt are optimal, but if the payor cannot afford the large payments, they may end up deeper in debt than originally. The key is to plan payments in a manageable way.
- Maintaining a checking account will also help with reduction of debt. Amerant Bank offers several checking accounts that can provide options for those in debt to begin rebuilding their financial health.
- Consolidate debt: A larger debt consolidation loan may be able to reduce overall monthly payments, such as by taking 3-4 credit cards with a total of $400 monthly payment and folding it into a home refinance that increases your mortgage payments by $100 a month, which would reduce monthly expenses by $300.
- The key to effective debt consolidation is to ensure new debt is not taken once the debt consolidation is completed. This allows for effective reduction of overall debt without the additional burden of managing new debt.
- Earn more income: While it’s not always an option, securing more income in the form of a raise, a second job, freelance work, or rental property can help by reducing your DTI by a few percentage points.
What Is DTI Used for?
With a good understanding of how to calculate DTI, it’s time to consider what it’s used for. Your debt-to-income ratio will have a significant impact on your overall financial well-being.
Mortgage Lending
Mortgage lenders look at DTI as a major indicator of a potential borrower’s creditworthiness. That is, mortgage lenders will use this ratio to envision how the mortgage will fit into the borrower’s finances. If the resulting DTI after securing the mortgage is in the healthy range, they may be much more motivated to provide the loan. On the other hand, if the applicant’s DTI is already nearing 40% or 50%, the mortgage is less likely to be approved.
How Do Lenders Calculate DTI?
Lenders may do their initial calculations based on information provided on the application but will inevitably pull a hard credit check before approving a mortgage loan. This check will include the sum of debt-related monthly minimum payments as well as other important expenses. Additionally, lenders may require at least a month’s worth of pay stubs, bank statements, and several years of prior taxes to determine your income.
Just as above, the lender will then divide the confirmed expenses by the verified income to establish your DTI for the proposed loan.
Auto Lending
As with mortgage lenders, auto loan providers prefer to see a DTI of 35% or below. As the car itself will serve as collateral for the loan, lenders may be willing to offer a loan with higher interest rates for those with higher debt-to-income ratios. However, the closer to 50% that your DTI is, the less likely it will be that the auto lender will approve the loan.
Debt-to-income ratio: a signal to lenders
Debt-to-income ratio is one of the “big picture” ways that lenders consider your overall creditworthiness. Although it pulls information from many sources, it simplifies your expenses and compares them to your overall income to give a simple percentage. In general, the lower you keep that percentage, the better terms you’ll be offered and the easier time you’ll have to get approval on mortgages and other loans.
To improve DTI, remember that you can pay down your debt, consolidate your expenses, or increase your income to move the numbers in your favor. If you’re concerned about your debt-to-income ratio, the best thing to do is to consult qualified financial advisors and specialists.
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