Understanding how creditors evaluate your creditworthiness is one step in the right direction toward achieving your financial freedom. After all, knowledge is power, and knowledge of how financial matters work can help you make your way out of debt into financial stability.
Key Points:
(Take one of our fun Debt IQ tests to test your knowledge now.)
Imagine your financial life as a balancing act between what you earn and what you owe. One of the most important tips when you apply for credit is to compare the ratio between the two, known as your debt-to-income ratio (DTI). Your lenders will want to know if you can afford to make payments and still pay for life necessities like groceries, gas, and any unexpected emergency. If your DTI is too high, you will be squeezed to make payments, and you are a high-risk borrower.
Your DTI tells lenders a compelling story about your ability to manage monthly payments, take on new debt, and pay off debt faster.
Your debt-to-income ratio is the sum of all your monthly gross debt payments divided by your gross monthly income. Your gross monthly income is how much money you earn before taxes and other deductions are taken out of your check.
Your debt-to-income ratio is the percentage of your monthly income that goes toward paying down debt. Understand it generally as a financial snapshot that shows how much of your income is already spoken for before you even cash your paycheck based on what you earn.
This calculation includes all your monthly debt payments divided by your gross monthly income (your income before taxes and other deductions).
For example, if you pay $1,500 in monthly debt payments and earn $5,000 per month before taxes, your DTI would be 30%. This simple percentage carries significant weight in your financial life and influences everything from mortgage approvals to credit card applications.
Monthly debt payments that must be included in your DTI calculation include more than you might expect, so let’s take a look at what qualifies as debt payment.
Your mortgage payment should include not just the principal and interest but also property taxes and insurance if they are part of your monthly account payment. Some people are surprised to learn that rent payments are considered debt for DTI purposes, even though rent isn't technically a payoff debt.
Private student loans must be included, even if they are in deferment. Once the deferment ends, lenders will use the expected payment amount.
For credit cards, you will need to include the minimum required monthly payment, not the total monthly debt balance or what you usually pay. This is where credit utilization comes into play—credit card balances that are near their limits can negatively affect your DTI.
An auto loan, a personal finance loan, and home equity loans or lines of credit all count toward your monthly debt obligations.
If you are paying alimony or child support, these court-ordered payments must be included in your debt calculations. The same goes for timeshare payments and any other type of loan that may appear on your credit history report.
Not every monthly bill counts as debt for DTI purposes. Your regular utility bills, including electricity, water, gas, and internet service, are not included unless you are paying off a past-due amount through a payment plan.
Likewise, insurance premiums (except when part of a mortgage payment), cell phone bills, and streaming service subscriptions don't count as debt.
Gym memberships and other subscription products and services aren't considered debt either, even if you're under contract. Medical bills aren't included unless you have taken out a loan or entered into a formal payment plan that you have used to pay them.
Future expenses, such as anticipated tuition payments or planned major purchases, also don't factor into your current DTI.
Your debt-to-income ratio is used by lenders to assess the level of your borrowing risk. A lower DTI suggests you have a healthy balance between current debt and income, with enough wiggle room to handle your monthly payments. Lenders view this favorably because it indicates you are less likely to default on new debt obligations.
Lenders can set their own requirements regarding acceptable debt-to-income ratios, but the ratios usually fall into some broad categories.
Most lenders prefer to see DTI ratios of 43% or less for major loans like mortgages, though some mortgage lenders may accept higher ratios to determine your eligibility in certain circumstances. The Consumer Financial Protection Bureau states: “The 43 percent debt-to-income ratio is important because, in most cases, that is the highest ratio that lets you get a Qualified Mortgage.” If you're unsure where you stand, a debt-to-income ratio calculator can help you quickly assess your financial situation.
What about lower DTI ratios, though?
Investopedia has this to say about a good debt-to-income ratio: “Ideally, lenders prefer a debt-to-income ratio lower than 36 percent, with no more than 28 percent of that debt going towards servicing a mortgage or rent payment. The maximum DTI ratio varies from lender to lender. However, the lower the debt-to-income ratio, the better the chances that the borrower will be approved, or at least considered, for the credit application.”
So, if possible, keep your DTI below 35%. This lower ratio not only improves your chances of loan approval but often comes with a better, lower interest rate and better terms, like some of the best personal loans and best high-yield savings.
A money market account may also help improve your overall financial situation. By saving and growing your funds in money market accounts, you may be able to increase your financial flexibility, which could help you manage your debt-to-income ratio more effectively over time.
Your debt-to-income ratio is important because it factors into a lender’s decision about whether to approve your loan. However, it is not technically a part of your credit score that lenders look at. They will also view all credit reports to add to the overall picture of how you handle your finances and whether you’re able to handle your credit limit and pay off credit.
To calculate your DTI you need to find the total amount of debt balance you can carry and your income. Start by totaling your monthly debt payments from your personal information, including:
Then, divide this total by your gross monthly income and multiply by 100 to get your percentage. Remember to use your pre-tax income for this calculation, as this is what lenders will consider.
Let’s say, if you make $5000 per month and your debts total $1700, then 1700/5000=0.34.
To find the percentage for this number, calculate it as follows: 0.34x100=34%. In this case, your DTI is 34%.
Your debt-to-income ratio affects far more than just loan applications. A high DTI ratio may impact your ability to:
Moreover, a high DTI often signals that you are carrying too much debt relative to your income, which can lead to financial stress and limited flexibility when faced with unexpected expenses like a car breakdown or a medical emergency. Additionally, managing your financial accounts, including checking accounts, can help you track your expenses and stay within budget.
Your credit image depends on your DTI so you have every interest in improving it. To improve it, you must focus on two things: reduce your debt and increase your income. You can try to focus on either one of these — or, ideally, on both. Here's how to work on both fronts:
Create a detailed budget that focuses on debt repayment.
Consider applying the debt avalanche method, where you focus on paying off debts with higher interest rates first while maintaining the minimum payment on other obligations. If you have a bonus or overtime pay coming up, direct this money toward debt repayment.
Look for the right opportunities to boost your earnings through side gigs, overtime work, or a new job. Even a small increase in monthly gross income can impact your DTI. Develop new skills that could lead to higher-paying positions or start a part-time or small business in your main field of expertise. Also, look for opportunities to increase your income through overtime, side jobs, or other streams. If you receive social security, consider how this income can contribute to your overall earnings.
One of the most frequently asked questions is how to avoid new debt. Avoid taking on new debt unless absolutely necessary. Each new loan or credit card increases your monthly obligations and could offset your progress. No matter how much you have missed going on a shopping spree, perhaps you should leave that for later.
Keep your healthy debt-to-income ratio. Create a sustainable budget that allows you to live comfortably while managing debt. Build an emergency fund and look for the best credit cards and best high-yield savings accounts. Review your spending patterns to find areas where you can reduce costs in some way.
Remember that while your DTI is important information, it is just one piece of your overall financial health. Keep track of other factors that can affect your credit score, saving rate, and investment strategy. An all-inclusive approach to financial management will serve you best in the long run.
ClearOne Advantage may be able to help you improve your debt-to-income ratio in two ways.
First, our team of negotiators may be able to negotiate with your creditors on your behalf to settle your debt and lessen the total amount of debt you owe. This will lower your DTI ratio quickly.
Second, as you work with ClearOne to make regular payments, you may be able to settle your credit card debts completely within 24 to 60 months. This is one of the best ways to lower your debt-to-income ratios by a substantial margin.
Call a ClearOne Certified Debt Specialist at 866-481-1597 and get a free savings estimate today.