Debt-to-Income Ratios and Why They Matter
A debt-to-income (DTI) ratio is the percentage of a person’s monthly gross income that is dedicated towards paying back debts. Your DTI ratio is an important piece of data that will help lenders determine the likelihood that you’ll repay a loan.
How to Calculate Your Debt-to-Income Ratio
Your DTI ratio can be calculated by adding up all of your regular monthly debt payments (student loans, credit card payments, mortgage, car loans, etc.) and dividing it by the amount of money you make every month (primary job, spouse’s monthly income, and money generated from second jobs or side gigs).
Total Regular Monthly Debt Payments ÷ Gross Monthly Income =
There are also two common DTI variations that lenders may examine before offering an individual a mortgage or a line of credit:
- Front-End Debt-to-Income Ratio: Also referred to as a “household ratio,” this is the percentage calculated by dividing your home-related expenses (property taxes, monthly mortgage payment, insurance and home association fees, etc.) by your monthly gross income.
- Back-End Debt-to-Income Ratio: This ratio is the rest of your monthly debt payments (credit cards, student loans, car loans, etc.) AND your monthly home related expenses divided by your monthly gross income.
When referring to front-end and back-end DTIs, lenders will notate the two numbers in a pair. For example, if they require a front end DTI of 28 and a back-end DTI of 35 for a borrower to qualify for a loan, this will be written as 28/35.
What is a Good Debt-to-Income Ratio?
When it comes to DTI ratios, lower is considered better (with ratios 20% and lower being considered excellent). For example, if your DTI ratio is 17%, this means that only 17% of your gross monthly income is being put towards existing debt payments and a portion of the other 83% can be dedicated towards paying back a new loan or mortgage.
Generally, if you have a higher DTI ratio, you may be considered a riskier borrower. An individual who has a DTI of 55% has less remaining monthly income to work with, which could mean trouble if an emergency expense is thrown into the mix on top of their monthly payments.
If you’re hoping to qualify for a mortgage, your DTI should be no higher than 43%. For general borrowing purposes, most lenders prefer debt-to-income ratios that are lower than 36% and front-end DTIs that are no higher than 28%.
How to Lower Your DTI Ratio
If your DTI is too high, there are a few steps you can take to improve it, including the following:
- Increase your monthly gross income by negotiating a raise or taking on a side job.
- Pay off as much of your current debt as possible.
- Don’t increase your debt, and use your existing credit responsibly.
It’s important to remember that your debt-to-income ratio isn’t the only information that lenders use to evaluate your creditworthiness – your credit history and credit score will also be taken into account. Still, calculating your DTI can give you a better sense of your overall financial health, and taking the steps to improve it can help you secure future loans.