When most people consider their financial health, credit scores are the first thing that comes to mind. However, another very important part to consider is your debt-to-income (DTI) ratio. Understanding your DTI helps you determine if taking on more debt is the right choice for you.
Why It Matters
Simply put, DTI is how much you owe each month compared to how much you earn.
Lenders take DTI into consideration when they deliberate on the risk associated with you adding on another monthly payment. Your DTI helps them establish if they should give you a loan and how much they should offer. If you can barely pay your current loan payments, they will worry you will fall behind on a new one.
A lower DTI can also make it easier for you to qualify for financial deals, such as refinancing your loans.
Ultimately, the most important reason why your debt-to-income ratio matters is that it can offer you peace of mind. Getting debt into a manageable position is crucial to having a stress-free financial life.
How to Calculate Your Debt-to-Income Ratio
Many tools exist to help you accurately calculate your debt-to-income ratio, but it can be pretty simple if you know what to look for. To calculate your DTI, start by tallying up your monthly bills:
- Rent or mortgage payment
- Alimony or child support
- Student loans
- Auto loans
- Credit card payments
When it comes to DTI, you don’t need to include regular expenses such as groceries, utilities, cell phone bills, or gas.
Start by dividing your total monthly bills by your gross monthly income, or how much you earn before taxes. The resulting percentage is your DTI. The lower it is, the less of a risk you are to lenders.
Generally speaking, you want to keep your DTI at 35% or less. This indicates that your debt is pretty manageable compared to your income and is appealing for lenders.
If your DTI is under 49%, you are just barely managing your debt, but an unforeseen expense could be devastating. Still, most lenders won’t refuse you if you’re within this percentage range.
DTIs over 50% mean that more than half of your monthly income is going towards debt payments, and lenders will not give you the same favorable options you may have with a lower percentage.
It’s important to note that having a high debt-to-income isn’t always bad, such as when you’re aggressively paying off your debt, but if you’re making only the minimum payments and you’re still above 50%, it’s not a good sign. You certainly shouldn’t borrow any more money in this case.
Improve Your Debt-to-Income Ratio
Having a high debt-to-income ratio severely impacts your financial life. You have less money to put towards savings or make payments on your daily bills, and an unforeseen expense could leave you in a very bad position.
When it comes to lenders, they see a high DTI as an indicator that you may be late on payments or default on the loan entirely.
There are only two ways to lower your DTI: increase your income and pay off your debt. If you can raise your income by taking on another job or by working overtime, this will improve your percentage.
Debt payoff strategies can help you tackle the existing debts you have to help lower your DTI. You might want to pay off the loan with the highest monthly payment, or combine several loans into a lower payment. This can include paying off your debt or even declaring bankruptcy. Your debt levels and personal situation will determine the best method to lower your DTI.
Get Expert Strategies
Regardless of how much debt you carry, there’s always a way to improve your financial health, so don’t give up hope. An expert can help tailor the best strategies for you to lower your debt-to-income ratio. Contact us to be connected to an experienced financial advisor.