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Debt-to-Income Ratio

Curious about your odds of getting approved for a loan to buy a house, a car, or start a business? Knowing your debt-to-income ratio (DTI) is a good place to start. This ratio provides an at-a-glance evaluation of how debt-burdened you are and whether you can reliably make monthly payments. It is one of the most important factors lenders use in the underwriting and loan approval process to determine the potential risk of loaning money to you.

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What is debt-to-income ratio?

Debt-to-income (DTI) ratio is a percentage that shows how much of your gross monthly income goes towards paying financial obligations such as rent, car payments, student loans, a mortgage, or minimum credit card payments. This calculation shows whether you can afford to take on new credit and reliably make monthly payments to pay off the debt.

The lower your DTI, the better. A higher number means that a significant portion of your monthly income is going towards your debts, which lenders see as an increased risk that you’ll default on future payments. Even with a great credit score, getting approved for a loan with a high debt-to-income ratio can be difficult.

Debt-to-income ratio is a great tool for evaluating cash flow and can be a helpful indicator of your financial health. However, it does not show a complete picture of a person’s financial situation such as a portfolio of investments or whether they reliably pay their bills on time. DTI is one of several measurements that evaluate financial wellbeing.

DTI Calculator

How to calculate debt-to-income ratio

The debt-to-income formula is simple: Total monthly debt payments divided by total monthly gross income (before taxes and other deductions). Then, multiply that number by 100. That final number represents the percentage of your monthly income used towards paying your debts.

Say you make $3,000 a month before taxes and household expenses. Your monthly debts include $1,200 for rent, $200 in student loan payments, and $100 in car payments, for a total of $1,500. Divide your total monthly debt payments by the total monthly income, $3,000, and the result is 0.5 or 50%. This means that 50% of your monthly income goes towards paying back your debts.

What types of payments are included in DTI?

A front-end DTI ratio only includes housing-related costs such as rent, mortgage payments (or future mortgage payments), home insurance payments, property taxes, or HOA fees. This ratio is typically only used by mortgage lenders when you buy a home. A back-end ratio includes all financial obligations like car payments or student loans and is used by most lenders. The DTI calculation does not include expenses such as food, utilities, insurance, or cellphone bills even if they are recurring. 

An easy way to determine which types of debt payments are included in DTI is to consider the types of payments that affect your credit score. A missed credit card payment would definitely be noted on your credit score. Forgetting to pay your cell phone service provider, however, wouldn’t carry the same credit penalties. That phone payment wouldn’t be immediately reported to a credit bureau and therefore doesn’t need to be included in your debt-to-income calculation.

Other types of payments to include in a DTI calculation are:

What is a good debt-to-income ratio?

The lower your DTI the better. Financial experts consider a good debt-to-income ratio as one below 36% (for a back-end ratio), which means that only 36% of your income goes towards repaying your financial obligations. However, most lenders accept a higher DTI of 41% or less, though the precise DTI ratio that lenders will accept can vary.

What do your DTI results mean?

A high debt-to-income ratio means that a significant portion of your income goes towards paying down your debts, leaving you with little leftover cash to put towards other expenses or set aside for saving–a red flag to potential lenders. Having less disposable monthly income can lead to a greater reliance on credit cards and thus, more debt. Plus, having a significant chunk of your income claimed by bills limits your ability to cover unexpected expenses like an ill-timed car accident or medical emergency.

A low debt-to-income ratio, on the other hand, indicates financial stability. It shows you’re not debt-burdened or bogged down with other financial obligations. Lenders view this positively because it means you have greater discretionary income and the financial means to take on more debt while also being able to afford other expenses that may arise.

If your DTI is less than 36%

You’re in great shape. Approval for most loans, including car loans and consolidation loans should be easy. Even mortgage approval should go smoother with a DTI in the optimal range. However, a great DTI ratio does not guarantee the best loan terms (which is instead primarily influenced by the elements that determine credit score).  As such, in addition to ensuring that your debt-to-income percentage stays low, make sure your credit score is healthy by maintaining a low credit utilization rate, making on-time payments, and keeping credit inquiries to a minimum.

If your DTI is between 36–50%

It will be challenging to get approved for loans or financing if your DTI is within this range–especially for a mortgage or auto loan. You’ll likely need a larger down payment or have greater cash reserves than someone with a lower DTI.

You may be able to quickly improve your DTI ratio by making extra payments towards a particular debt or increasing your monthly income, perhaps by taking on a part-time job. If you can’t eliminate at least some of your debt effectively on your own, it’s time to explore debt relief.  Less debt improves your debt ratio, as well as your credit score. It’s a win-win.

If your DTI is greater than 50%

This is a sure sign of financial distress. If you spend over half your income paying bills, you’re probably struggling elsewhere and have a low likelihood of being able to contribute towards your savings. This sort of financial situation isn’t sustainable and you could potentially be headed for bankruptcy. Consider seeking professional help to reduce debt levels as quickly as possible.

Debt-to-income ratio & loan approvals

The sweet spot for most types of loan approvals is a DTI of 41% or less, but different types of loans may have special considerations. In addition to reviewing your existing debt-to-income ratio, some lenders may also consider your future DTI as well. This looks at how the potential new monthly payments factor into your existing financial obligations.  Some lenders want applicants with DTI below 41% with the new loan payments factored in. Even if you have a low DTI ratio, you still may need to continue working on reducing your debts.

DTI for a Personal Loan

When applying for personal loans, lenders typically like a DTI of 40% or less. Individuals with DTIs of 43% or higher are reported to have increased difficulty paying their bills.

DTI and mortgage approval

Let’s say you apply for a new mortgage. You calculate your DTI and it’s right on the cusp of approval at 39%. However, that’s your current debt ratio. For your future DTI, the underwriter would remove your current mortgage payments if you’re selling your house. Then they would add in the estimated payments on the new mortgage. As long as this DTI is 41% or less, you receive approval. If you plan to buy a comparable house to what you own now, you should be fine. But if you want to upgrade to a bigger house with a larger mortgage, they could reject the application.

This is why it’s in your best interest to reduce your debt load as much as possible before a major loan application. Eliminate student loan debt and credit card debt to fix your ratio before you shop around. It will make the underwriting and approval process much smoother.

DTI and debt consolidation loans

When you apply for a debt consolidation loan, the lender will also calculate your debt ratio during underwriting. In this case, your DTI determines whether they deliver the funds to you or disburse them directly to your creditors.

  • If your future DTI calculation with the loan and your credit card debts included is below 41%, then can disburse the money directly to you
  • However, if your DTI with the loans and credit cards included is above 41% they will require direct disbursement to your creditors

Typically, you have high debt levels when you consolidate. But once you pay off your credit cards it should fix your DTI (that’s why you use debt consolidation). So, the lender will only grant approval on the consolidation loan if they know your credit card debts will be paid off. Sending the money directly to your creditors (direct disbursement) ensures that happens.

Federal student loans don’t require DTI for approval

One of the few types of loans that don’t factor DTI in during underwriting is federal student loans. For these, approval is based on need. Your debt level and credit score never factor in, which means it’s easier to get approved.
The tradeoff is that you can end up with way more debt than you can afford. Students graduate with an average debt level of $35,000 in student loans. Most entry-level salaries would lead to a DTI of more than 41% based on that alone.

Payday loans also don’t care about DTI

If you have a high debt ratio, payday loans are often where you turn. The underwriting process for short-term installment loans is different. Neither your credit score nor your DTI matter. But that shouldn’t make you feel good about taking out payday loans. While they don’t consider DTI during payday approval, payday loans DO factor into DTI for other financing. So, payday loans trap you in a cycle of only being able to take out other payday loans. Given the excessively high-interest rates, it’s almost never worth it.

Does debt-to-income ratio affect credit score?

No, your DTI does not affect your credit score in any way. There is often a correlation between a low DTI and a high credit score because having less debt is always looked upon favorably, but they are not the same thing. A financial measurement that does count towards your credit score is debt-to-credit ratio, better known as the credit utilization ratio.

Credit utilization accounts for 30% of your FICO score. It is the most important factor in determining credit scores, second only to payment history.

Debt-to-income ratio vs credit utilization rate

Both DTI and credit utilization are calculations used to assess a person’s creditworthiness and can provide some insight into their overall financial health. Whereas DTI measures cash flow, credit utilization, as its name implies, is solely concerned with credit usage–revolving credit card debt. 

Simply put, your credit utilization rate is a measure of how much of your available credit you’re using. This percentage can indicate how reliant you are on credit cards. It’s recommended to keep your credit utilization ratio below 30%, meaning that you use only 30% or less of your total available credit. A high credit utilization rate can mean you’re maxing out credit cards (or close to it), a sign of potential financial distress.