If you want to manage your money responsibly, you probably already know that you should review your finances at least once a month. You might also check your bank account for unauthorized charges, make sure your bills are all paid, and look at your credit score periodically. But you still may not have a complete picture of your finances if you aren’t reviewing your debt-to-income (DTI) ratio along with all of these other factors.
So, what’s a good debt-to-income ratio? Simply stated, the lower the better. A high debt-to-income ratio makes it harder to get a loan and could also be a warning sign that your overall credit health—and your credit score—may be heading downhill.
Monitoring your DTI could provide early warning signs that you need to start cutting back expenses or managing your debt better. That’s why it’s important to keep track of your debt-to-income ratio, understand how to calculate it, and know how to reduce your debt-to-income ratio if it’s too high.
What is debt-to-income ratio?
What is DTI? It’s the percentage of your monthly income that goes toward paying your debt and the resulting amount of income you have left over at the end of the month, after you have paid your bills. Your creditors calculate your DTI to understand how much your current debt impacts your finances, allowing them to figure out how much additional debt you can afford.
If a creditor thinks that your debt-to-income ratio is too high, they may consider you a borrowing risk and decide not to lend to you. On the other hand, you could get approved for a loan or mortgage more easily if you have a lower debt-to-income ratio because your creditors may feel that you will be more likely to pay back the loan since your money isn’t already tied up in other debts.
Unless you are making a major purchase that adds to your debt amount, your goal should always be to lower your debt-to-income ratio so that you can focus on saving for the future. The less dependent you are on debt, the more energy you can put toward building wealth and preparing for emergencies by saving your extra money in an emergency fund.
What’s the difference between debt-to-income ratio and credit score?
It’s true that a low debt-to-income ratio could help you qualify for a loan and a lower interest rate, but your credit score is also a major part of a creditor’s decision making process. While your DTI might help a creditor decide how much to lend to you, your credit score could also affect your loan terms, like the length of your loan and your annual percentage rate (APR).
The credit score really matters when you are looking to take out a new line of credit, like a loan or mortgage. Your payment history, credit utilization, and credit history all contribute to your credit score, which in turn helps creditors determine your likelihood to pay back the loan (referred to as your creditworthiness). If you have a low credit score, you may have a hard time getting a low interest rate on the loan.
Debt-to-income ratio, on the other hand, helps creditors know if they should lend to you in the first place. If they decide that it’s too high, they won’t lend to you. As a result, your debt-to-income ratio and credit score both contribute to your creditworthiness.
How do you calculate debt-to-income ratio?
It’s simple to calculate your debt-to-income ratio on your own, and you should do it regularly. All you need to do is add up all of the monthly debt payments you make to credit cards, personal loans, mortgages, and any other debt. Then, divide that total number by your gross monthly income (before taxes). Finally, multiply the number by 100 to get the percentage of debt to income.
In mathematical terms, this is how to calculate debt-to-income ratio:
([Total Debt Payments] / [Gross Income]) x 100 = [Debt-to-income ratio]
For example, if you put a total of $2,500 towards your debt every month and your monthly income before taxes is $6,000, your debt-to-income ratio would be 41.67 percent.
What’s a good debt-to-income ratio?
Every lender has slightly different criteria, and other factors also may contribute to their lending decisions, however, the following provides a general idea of what is a good debt-to-income ratio and how it could impact your creditworthiness.
- Below 36%: Almost any creditor will consider you for a new mortgage or loan because they feel confident that you will be able to cover the additional monthly payments.
- Between 37% and 49%: Some creditors may consider you a credit risk but might lend to you anyway.
- Above 50%: You will most likely have trouble being approved for a new line of credit because creditors may consider you a high credit risk who will won’t be able to pay for any additional debt.
If you plan to apply for a mortgage or other large loan, it’s a good idea to keep your debt-to-income ratio low. Similarly, decreasing your debt-to-income ratio is a good idea if you are trying to improve your finances because it gives you more opportunities to save money.
What does your debt-to-income ratio say about your financial well-being?
Your debt-to-income ratio matters not only if you are trying to get a loan, but also if you want to grow your wealth. Your DTI provides you with a fast, easy way to determine whether you’re earning enough to cover your expenses and save for the future.
Having a high debt-to-income ratio usually means you aren’t able to save as much as you would like each month because you’re spending too much of your income on your debt. Having a lower debt-to-income ratio means you’re living a lifestyle you can afford.
When should I be concerned about my DTI?
If your debt-to-income ratio is 35 to 40 percent, your finances may be at risk. Not only does having a high debt-to-income ratio make it extremely stressful and difficult to pay for emergency expenses like home or car repairs, it also means that if you suffer a sudden financial hardship—like a job loss or illness—you may simply not have the funds you need to cover your debts.
Even one missed payment could negatively affect your credit score and trigger a high default APR, making it harder to pay your bills and causing you to miss more payments. If you’re worried that your debt-to-income ratio is too high, there are solutions that could help you reduce it.
How could you reduce your debt-to-income ratio?
If you want to reduce your debt-to-income ratio, you need to reduce your debt and/or increase your income. And while you certainly can try to get a raise at work or find a better-paying job, you probably have more direct control over reducing your debt than increasing your income.
One of the least effective approaches, at least as far as credit card debt goes, is to make minimum payments to pay off the debt. Making minimum payments means you are paying only a small portion of the principal owed and, over time, will end up paying much more in interest rates. If you want to get rid of credit card debt, you need to pay more than the minimum owed each month.
A better choice could be a debt consolidation loan because it could enable you to move your debt from a higher interest to a lower interest, saving you money in the long run. The problem is that you might have trouble qualifying if you already have a high debt-to-income ratio, since lenders may think you are too risky. And since it’s just another form of debt, it may not have a significant impact on your debt-to-income ratio.
If you’re having a hard time making minimum payments each month and can’t qualify for a debt consolidation loan, another option is a debt settlement program. This involves stopping payments, putting money into a dedicated savings account, and then negotiating with creditors for lowered balances. Once these lowered balances are paid off (using money set aside in the savings account), the debts are considered paid in full.
While you can do it on your own, a professional debt settlement company often will have more inside knowledge of how creditors operate and can get lower settlements.
Take control of your DTI and your financial future
If you are struggling with debt and have a high debt-to-income ratio, it may seem impossible to dig yourself out of debt. But Freedom Debt Relief can help you understand your options, including our debt settlement program. Our Certified Debt Consultants can help you find a solution that will help you decrease your DTI and put you on the path to a better financial future. Find out if you qualify right now.