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What Is Debt-to-Income Ratio?
A debt-to-income ratio measures the amount of debt a person has relative to their income. This number, expressed as a percentage, basically represents your ability to manage your existing debt payments on your current earnings and still have room in your budget for things such as savings or “fun” spending. From a lender’s point of view, your DTI indicates whether you can afford to take on another monthly payment without overextending yourself financially.
How debt-to-income ratio is calculated
The concept behind your debt-to-income ratio isn’t that hard to understand. Basically, it’s the amount of debt you have compared to your income.
If you want to get fancy, the Consumer Financial Protection Bureau (CFPB) explains debt-to-income ratio as “all your monthly debt payments divided by your gross monthly income.” To calculate your debt-to-income ratio, just add up all your monthly debt obligations — including car payments, student loans, credit card minimum bills, and your potential mortgage — and divide them by your gross monthly earnings.
Here’s how it might work: Let’s say you have approximately $3,000 in debt payments each month, including housing, and earn $60,000 a year before taxes (that’s your “gross” income). Divide that salary by 12 months, and you’ll find that your gross monthly income is $5,000.
If you take your monthly debt payments ($3,000) and divide them by your gross monthly income ($5,000), you’ll get a debt-to-income ratio of 0.60, or 60%.
How to lower your DTI
It’s possible to lower your DTI even if you can’t grow your income or increase your overall debt payments. Here are some options:
- Hasten your payment schedule. Instead of making one lump-sum payment on your credit card each month, split the money in half and pay that amount every two weeks. This reduces your average daily balance, and by extension your interest charges, allowing you to eliminate that debt faster without impacting your cash flow.
- Prioritize your highest “bill-to-balance” ratio. Paying more than the minimum monthly payment is always your best option. If you have multiple credit cards, tackle the one with the highest bill-to-balance ratio first. By allocating more money to the card whose minimum payment represents a higher percentage of its overall balance, you’re making a bigger dent in your DTI ratio. (Don’t forget to make the minimum monthly payments on your other cards, though.) .
- Consider a balance transfer. When you move existing debt to a credit card with a lengthy 0% balance transfer period, your entire monthly payment is applied to principal rather than interest (which, again, accelerates the timeline for whittling that balance down to zero).
DTI and credit score
Credit-scoring models don’t take earnings into account, so your debt-to-income ratio doesn’t impact your credit scores directly. Credit agencies do consider your credit utilization ratio, which is the amount of revolving credit you use relative to your overall credit limits. (The more debt you have, the higher both ratios will be.)
Most lenders calculate your DTI using the account balances in your credit report and the income listed on your application. As you might guess, a too-high DTI could signal that you’ve taken on too many monthly payments and may not be able to handle another one. If a lender views you as a higher risk, it could assign you a higher interest rate, if it approves you at all.
Lenders set their own DTI limits, but generally, a DTI below 36% (the lower, the better) is what you should aim for, particularly if you’re applying for a mortgage. With credit scores, the inverse is true: The higher your score, the more favorable a lender will view you as a borrower.
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