- Get Out of Debt
Your Debt to Income Ratio (DTI) is a basic calculation used to express affordability. You can use a DTI calculator to find your own ratio.
How to Calculate Your Debt to Income Ratio
Your DTI is calculated by combining all of your debt repayments and subtracting them from your total income, before expressing the calculation as a percentage. Use your gross monthly income and include rent/mortgage payments in your total outgoings.
As an example, if you earn $5,000 a month but pay $500 in rent, $250 in credit card payments and $250 in personal loan payments, then your ratio is 20%. This is considered low. However, if your income is just $2,500 and you have the same outgoings, then that ratio becomes 40%, which is considered high enough to cause financial stress.
How Important is It?
Lenders use the Debt to Income Ratio to estimate a borrower’s ability to make repayments. If we use the above calculation as an example, you have just $1,500 leftover every month after rent and minimum payments. If we add food, travel costs, and other essentials to the mix, that could drop as low as $500.
That will be a huge red flag to a lender, who will seriously doubt your ability to make future repayments. A DTI above 40% will also impact your chances of getting a mortgage, with many lenders refusing to lend to anyone above 43%.
There are still personal loans available to consumers with a high DTI, but in these cases, they are supplied with a view to consolidation. The same goes for student loan refinancing.
How Your DTI Affects You
Your DTI does not directly affect your credit score, because the credit bureaus do not display your income or factor it into the equation. However, they do calculate something known as credit utilization, which works in a similar way.
Credit utilization is a comparison of the amount of credit that you have available versus the amount of credit that you use. A high score shows lenders you’re desperate to take what you can get and are more prone to maxing out credit cards; a low score suggests the opposite, hinting at more responsibility.
Credit utilization should be kept below 30%. This means you should avoid borrowing more than $3,000 on a $10,000 line of credit. Credit utilization accounts for 30% of your credit score and is a key factor in calculating your score, so it’s worth paying attention to.
One of the easiest ways to improve your credit utilization is to increase your current credit. Contact providers and ask them for a higher limit. This will increase the amount of available credit without increasing the used credit.
How to Improve your Debt to Income Ratio
We’re stating the obvious here, but there are two ways to improve your Debt to Income Ratio, you can either earn more, or pay less. The former is easier said than done, but there are more options for the latter:
- Pay more than the minimum – it may seem counterintuitive and won’t do you any favors in the short-term, but in the long-run it will clear more of the principal, lower the interest rate, and improve your rating.
- Use windfalls and savings to clear debt – that vacation in the sun may seem like a great idea, but a few years’ peace of mind and easier access to credit and a mortgage is better than sunburn and beachside cocktails.
- Avoid acquiring new debt – avoid taking any new credit, even if you qualify for it.
- Keep an eye on your DTI to monitor your progress – it helps to know how fast you are progressing. You can use our Debt to Income Ratio calculator for this.
DTI and Credit
To give you an idea of how much your DTI affects your finances, here is a rough guide based on percentages acquired through our Debt to Income Ratio calculator:
- DTI Score up to 15%: A low and favorable score, but as with all forms of debt, it’s worth monitoring your situation to ensure it remains that way.
- DTI Score Between 15% and 25%: A ratio considered relatively safe and low. You shouldn’t have any issues.
- DTI Score Between 25% and 40%: At this point things begin to look ominous, but it’s still salvageable. You will be offered higher rates when applying for new credit and should seek help via debt management.
- DTI Score Over 40%: Look into debt settlement, management or counseling. You are on the verge of being rejected for mortgages and will struggle to get loans and new lines of credit.
- DTI Score Over 50%: You may qualify for some consolidation loans or refinancing options, but this is a severe state and requires immediate attention.
DTI Isn’t Everything
It’s important to remember that your Debt to Income Ratio score is just a rough calculation of affordability. It is used by lenders to determine whether you can afford to meet repayments, but it’s not the only thing they consider, nor is it the most important.
It’s not uncommon to have a high income and a fantastic credit score as well as a DTI of between 30% and 40%. In such cases, everything discussed on this page, including your score in our Debt to Income Ratio calculator, may seem a little strange. In such cases, just remember that the DTI is there for your benefit as well as the benefit of lenders. It’s a small red flag telling you that you should look into fixing your debt before acquiring any more credit or making any big financial decisions.
It goes without saying that you can’t remain financially secure for long if more than a third of your income is spent on minimum payments, especially if you don’t own your own home and have any savings.