What Is Your Debt-to-Income Ratio?
If you're applying for a mortgage loan, an auto loan, or even just a regular personal loan, lenders will be looking at your DTI to see whether or not you can afford it.
When it comes to the numbers that rule your financial life, you’re probably familiar with the big ones like your credit score: Even if you don’t have good credit, you still know that you should try to keep your score as high as possible.
But there’s another important number that you might not be so familiar with: your debt-to-income ratio. And while it’s luckily one of the simpler money metrics out there—unlike, say, your credit score—it can have massively important implications for your financial future.
What is the debt-to-income ratio?
“Your debt-to-income ratio (known as DTI) is an important financial metric that you really do need to understand,” explained CFP Patricia Russell, founder personal finance blog, FinanceMarvel. And while some financial terms—like “amortization” for instance—can be slightly opaque, your debt-to-income ration is not one of them.
“In simple terms, your DTI ratio is all of your monthly debt payments divided by your gross monthly income (expressed as a percentage),” said Russell. “This metric or ratio is heavily scrutinized by lenders to assess your ability to service your monthly repayments on the money you have borrowed.”
It’s important to emphasize that your DTI doesn’t measure your total debt load to your total yearly income. Instead, as Russell laid out, it measures the amount of money you’re obligated to pay towards that debt every month against your monthly income.
“It’s a ratio that affects your ability to access a loan,” said millennial money expert Robert Farrington, founder of TheCollegeInvestor.com. “The basic idea is if you have too much debt relative to your income, lenders might hesitate or refuse to give you the credit you need for a large purchase.
“Your debt-to-income ratio (DTI) most often comes up when buying a house,” he continued, “but it is also considered by potential landlords or lessors of cars. By pulling your credit report, someone can calculate your DTI and decide whether to loan, rent, or lease to you.”
What kind of debts and income count?
According to Farrington, the debt obligations factored into your DTI are those that fall under the category of “recurring” debt, or debts that you can’t simply cancel at any time.
“This includes mortgage, rent, car loans, personal loans, monthly minimum credit card payments, alimony, child support, and, of course, student loans. These are debts that are not going to go away until you’ve fully repaid them,” he said.
And which debts do not count towards your DTI?
“Despite the fact that you may have contracts with your internet, cable, or phone provider, you can technically pull the plug on these services any time, so they do not count. Nor do other kinds of utilities like electricity and water,” said Farrington.
He also went to explain which sources of income count towards the other half of the ratio. In short, it doesn’t just have to money that you earn from a job. “Your income can include not just wages, salary, and tips, but also alimony and child support, Social Security benefits, and pension,” he said. “Pretty much any money you take in on a monthly basis on the books can be considered income.”
How can you calculate your DTI?
Knowing what a DTI is won’t do you a ton of good if you can’t figure out how to calculate it. Luckily, figuring out your DTI is pretty simple and doesn’t require a financial advisor.
“To calculate, one simply takes all debt payments and divides by gross monthly income,” said Robert R. Johnson, Professor of Finance in the Heider College of Business, Creighton University. “This includes all debt payments—mortgages, student loans, auto loans, credit cards, etc.”
To give you an idea of what this process looks like, Farrington helpfully provided the following example: “If you have $1,000 per month in debt obligations and $3,200 per month in income, divide 1,000 by 3,200 and your answer is .3125. Round that to .31, multiply by 100, and you have a 31% DTI ratio—Meaning that 31% of your income is taken by debt obligations per month.”
What is a good debt-to-income ratio?
When lenders are looking at your DTI, it’s to help them determine whether or not you can pay back the loan you’re applying for—the same goes for landlords. As such, you want to try and keep your DTI fairly low. But the thresholds for what is an acceptable ratio can change depending on what kind of loan (or lease) you are applying for.
When it comes to applying for a mortgage loan, Farrington cites Fannie Mae guidelines that say 50% is the acceptable DTI ceiling for prospective homebuyers. But just because 50% is the ceiling, doesn’t mean you shouldn’t aim lower. And the data backs that up.
“According to the Consumer Financial Protection Bureau (CFPB), the highest ratio a borrower can have and still be eligible for a Qualified Mortgage is 43%,” said Johnson. “And, a Qualified Mortgage is a category of loans that have certain, more stable features that help make it more likely that the borrower will be able to afford the loan.
“According to the CFPB, evidence from studies of mortgage loans suggests that borrowers with a higher debt-to-income ratio are more likely to run into trouble making monthly payments,” he added.
If you’re looking to take out an auto loan, Farrington says that a DTI of 36% or below is ideal to get a reasonable deal. Meanwhile, if you’re applying to rent a house or an apartment, he cautioned that DTI will vary, largely by location and property owner.
“Many landlords will require that the rent will amount to no more than 33% of your income. Some may be more lenient and go up to 45% or 50%,” he said.
If you’re looking for a good overall ratio to set as your goal, aim for something just south of 30%. “An ideal ratio is generally around 28 percent although as mentioned above lenders will accept a higher ratio depending on other factors including your credit score, your savings levels, other assets you own,” advised Russell.
But she also warned that folks shouldn’t necessarily count on a good credit score saving you from a high DTI: “Whilst credit bureaus don’t look at your DTI ratio, often a borrower who has a DTI ratio also has a high credit utilization ratio which does count for around 30% of your credit score.”.
Johnson agreed with 28% figure, while also reiterating that the lower your ratio was, the better off you’ll be.
How can you improve your DTI?
If you’re looking to take out a big loan and you have a high debt-to-income ratio, it’s probably best to wait. In the meantime, Russell shared three ways that people can tackle their debt and improve their DTI.
- “Create a budget to track your spending: By keeping track of exactly where your money is going, you will often find unnecessary and extravagant daily expenses. This could be something as simple as a daily $5 coffee, which over a year is $1,825 that could go towards paying down your debts.”
- “Prepared a strategy to pay off your debt: My two favorite methods are the snowball and avalanche methods. How the snowball method works is that you start by paying off your smallest debt first whilst making the minimum payments on your other loans. Once you have paid off the smallest you then work your way onto the next one etc. With the Avalanche method, you focus on paying off the loan with the highest interest rate first. Whichever method you choose it’s important to stick with it.”
- “Don’t take on more debt: In order to get your debts under control, you need to avoid the temptation of taking on more debts. Don’t rack up unnecessary credit card debts and avoid major purchases like a new car on finance. New loans will really hurt your DTI ratio and won’t help your credit rating either.”
Paying down your debt is important for your financial health. But it might not be wise to throw yourself into debt repayment if it means foregoing other important financial priorities.
“Achieving financial security is not a linear process,” said Johnson. “By that, I mean that you often have to work on several competing goals at once. For instance, some people are so intent on extinguishing their credit card debt—certainly a worthy goal—that they choose not to participate in a workplace 401k plan.
“A 401k plan affords the participant many advantages,” he continued. “First, the contributions made reduce your income tax bill by reducing taxable income. Second, if the employer matches contributions—essentially you receive an immediate 100 percent return on investment. When one doesn’t participate in an employee matching plan, one is essentially turning down free money.”
Your DTI is important, but so is saving for retirement, building an emergency fund, and a whole host of other financial priorities. Take things slow and steady, and you should come out a winner on the other end.
Robert R. Johnson, PhD, CFA, CAIA is a Professor of Finance in the Heider College of Business, Creighton University (@CreightonBiz). He is also Chairman and CEO of Economic Index Associates, home to a new paradigm in Index investing. Dr. Johnson is the co-author of the books Invest With the Fed, Strategic Value Investing, Investment Banking for Dummies, and The Tools and Techniques of Investment Planning.
Patricia Russell is a Certified Financial Planner (CFP) and the founder of the personal finance blog, FinanceMarvel, which provides free financial advice on managing credit, debit and savings. Patricia has more than 10 years experience in helping families and individuals take control of their personal finances and achieve financial independence.
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