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 check your bank account for unauthorized charges, make sure your bills are all paid, and even look at your credit score periodically if you are especially financially savvy. But you may not have a complete picture of your finances if you aren’t reviewing your Debt-to-income ratio along with all of these other factors.
Debt-to-income ratio (DTI) tells you what percent of your monthly income goes towards paying your debt. If you have applied for a new mortgage or loan recently, you may already know that your Debt-to-income ratio played a role in whether or not you got the loan you wanted. You may also know that a high debt-to-income ratio makes it harder to get a loan. What you might not know is that a high debt-to-income ratio could also be a warning sign that your overall credit health—and your credit score—may be heading downhill.
You might think that as long as you have a high credit score, you don’t have to worry about your finances. But the truth is that you could be drowning in debt and still keep your credit score afloat by simply making minimum monthly payments.
Credit score is important, but it’s not the only indicator of your overall financial health. Your credit score is simply a number that creditors use to determine your likelihood of paying back a loan. It doesn’t reflect your entire financial situation, and it can change for any number of reasons. In fact, you may not even realize that your debt is getting dangerously high if you only look at your credit score, because the amount of debt you have is only one part of how your credit score is calculated.
Unlike credit score, which shows how responsible you are at managing debt and paying back your creditors, debt-to-income ratio tells you how much of your money goes towards repaying your debt relative to the amount of money you make each month.
Monitoring your debt-to-income ratio could help you see early warning signs that you can’t afford your debt and help you figure out if you need to start cutting back expenses and/or start 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?
Debt-to-income ratio is the percent of your overall monthly income that goes to paying your debt. Basically, it measures the amount of income you have left over at the end of the month, after you have paid your bills. Your creditors calculate your debt-to-income ratio to understand how much your current debt impacts your finances, allowing them to figure out how much additional debt you can afford to take on. The higher your debt-to-income ratio, the more your debt is eating into your income and leaving you less money each month for savings, investments, and emergency expenses.
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.
In managing your personal finances, you can calculate your debt-to-income ratio yourself to make sure that you are maintaining good spending habits and paying down your debt instead of increasing it and leaving yourself less able to save or fund future investments.
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 into building wealth and preparing for financial 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 debt-to-income ratio might help a creditor decide how much to lend to you, your credit score could affect your loan terms, like the length of your loan and your annual percentage rate (APR).
The only time that credit score really matters is when you are looking to take out a new line of credit, like a loan or mortgage, or if you are applying for certain federal jobs. Almost every creditor looks at your credit score before deciding on your loan terms to see if you are a good candidate to lend to.
Your payment history, credit utilization, and credit history are all factors that contribute to your credit score, which in turn helps creditors determine your likelihood to pay back the loan (which is 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. If you have a higher credit score, creditors are probably more likely to offer you more favorable terms, including a lower interest rate.
Debt-to-income ratio helps creditors know if they should lend to you in the first place. If they decide that your debt-to-income ratio is too high, they won’t lend to you. When it comes down to it, your debt-to-income ratio and credit score both contribute to your creditworthiness. So if you have an excellent credit profile and low debt-to-income ratio, a creditor may consider you an excellent candidate for a loan, mortgage, or other line of credit. If your debt-to-income ratio is high and you have a low credit score, you’ll have a much harder time getting a loan.
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 so you can always have a sense of how much of your income is going just to pay down debts. 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])x100=[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%.
What debt-to-income ratio should you aim to have?
If your debt-to-income ratio is 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. If your debt-to-income ratio is between 37% and 49%, some creditors may consider you a credit risk but might lend to you anyway. However, if your debt-to-income ratio is 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 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 a lower debt-to-income ratio gives you more opportunities to save money. But debt-to-income ratio is also a good way to tell if you are maintaining good financial standing, or if your finances are at risk.
What does your debt-to-income ratio say about your financial well-being?
Your debt-to-income ratio doesn’t only matter if you are trying to get a loan. It matters if you want to grow your wealth. Because your debt-to-income ratio provides you with a fast, easy way to answer the question “Am I earning enough to cover all my expenses AND save for the future?” Having a high debt-to-income ratio usually means the answer is “no”—you aren’t able to save as much as you would like each month because you are spending too much of your income on your debt. Having a lower debt-to-income ratio means the answer is “yes”—you are earning enough income to cover your debts and are living the lifestyle you can afford.
If your debt-to-income ratio is hovering around 35-40%, 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. Faster than you might think, you could find yourself deep in debt and at risk of going even deeper.
If you’re worried that your debt-to-income ratio is too high, the good news is that there are solutions that could help you reduce it. While there are many ways to deal with a high debt-to-income ratio, some methods are better than others.
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.
While you have many options when it comes to reducing debt or even eliminating it altogether, 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 principle 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.
If you are unable to pay more than minimum payments, this may seem counter intuitive. After all, as long as you are at least making minimum payments, you are helping pay the debt and will be able to avoid hurting your credit score. While it may be true that making minimum payments can help your credit score, minimum payments are not effective at reducing debt – so it won’t be helpful at reducing your debt-to-income ratio. And remember, paying only the minimums keeps you in debt longer, and the added interest accrued over that time means you’ll end up paying more than you owed in the first place. If you want to reduce your debt more than you want to protect your credit score, making minimum payments is not the right option.
A better choice than making minimum payments 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, because as we explained above, lenders may think you are too risky. And since debt consolidation loans are just another form of debt, it may not have a significant impact on your debt-to-income ratio and you will still have to pay interest on top of your principle debt. To make matters worse, if you have a high debt-to-income ratio yet still get approved for a loan, the interest rate you are offered may be so high that it doesn’t end up saving you much money after all.
If you are struggling to pay minimum payments each month and cannot qualify for a debt consolidation loan, an option you should look at to resolve your debt could be the Freedom Debt Relief program. If you qualify, we could design a customer program that helps you resolve your debt in as little as 24-48 months*, thereby reducing your debt-to-income ratio. It works because our negotiators work with your creditors to get them to reduce the amount you owe so you can reduce your debt faster, for less. Request a free debt consultation now.