WTFinance is debt-to-income ratio and how does it work?
Not long ago, when I was shopping around for loans, I learned that lenders look at something called DTI.
Maybe you're with me when I say that all these financial acronyms and jargon can make you feel like you're swimming in a bowl of alphabet soup. Maybe even in another language. And if you're nodding your head in agreement, know that you're not alone.
So what exactly is a DTI ratio and how does it work?
What is your debt-to-income ratio?
Debt-to-income ratio (DTI) is simply your total monthly debt payments divided by your gross (aka pre-tax) monthly income—shown as a percentage.
Here's an example:
Monthly pre-tax income: $4,500
Car loan: $500
Rent: $1,000
Credit card minimum payments: $300
Your total monthly debt payments are $1,800. So, in this example, the DTI is 40%.
1800/4,500=40%
How does debt-to-income ratio work?
In short, lenders and creditors figure out your DTI to get an idea of how much your current debt situation impacts your finances.
What debts are included in your DTI?
Your housing payment (that would be your rent, or if you own a home, your total mortgage payment including taxes, insurance, and homeowner association dues)
Other home loans, such as a home equity loan or home equity line of credit (HELOC—another acronym!)
Other loans, like a student loan, car loan, or personal loan
Your credit card minimum payment amounts
Bills that you have to pay, like child support, alimony, or a timeshare
Any debts that you’ve co-signed, even if you’re not the primary borrower
What debts are excluded from your DTI?
Some lenders exclude loan payments if the loan is due to be paid off very soon. Also, if you’re letting the lender use your loan to directly pay off your other creditors, those minimum payments shouldn’t count against you since they’ll go away when the balances are paid.
What are the risks of a high DTI?
The higher your DTI, the less new debt you can afford.
Here’s a simplified example. Let’s say you earn $1,000 per month and the lender’s DTI limit is 43%. That means you can only have $430 in debt obligations each month. If your DTI is 30%, that means you could be approved for a loan with a $130 payment.
Some people apply with a co-applicant to increase the income side of the equation. The lender will consider both incomes and both people’s debts.
What's a good debt-to-income ratio?
Generally, a good DTI ratio is 36% or below (or 43% if you include your housing payment). This signals to lenders that you most likely have money left over after paying your debts and other bills.
Some mortgages are available to applicants with a DTI of 50% or higher, but for other kinds of loans the limit is almost always lower.
Don’t assume you won’t qualify, even if you have a lot of debt. It’s best to talk to a loan expert about the details of your situation and the options that might work for you.
How to improve your debt-to-income ratio
There are two ways to improve your DTI. You can increase your income or lower your required monthly debt payments. Here are some possible strategies.
Pay extra toward your debts each month
Take money out of savings to make a one-time big payment against your credit card balance
Apply with a co-applicant if using both incomes will lower your combined DTI
Use a new loan to consolidate multiple debts. This can lower your total required monthly debt obligation.
Get a side job with documented income. Every little bit helps.
Avoid increasing your debts. No large credit card purchases if you can help it.
Talk to a professional loan advisor about your situation for more guidance.
