The Importance of Debt-to-Income Ratio and Why It Matters

Whether you're planning to buy a house or refinance your student loans, there's another number you should be aware of in addition to your credit score. It's your Debt-To-Income (DTI) Ratio. 

The DTI is an important marker used to determine your ability to repay a loan as a borrower. If your DTI is too high, your chances of getting approved for a bigger loan may be limited. In addition to your credit history, lenders look at your DTI to determine your likelihood of repaying your monthly mortgage payments on top of your recurring debts.

As a borrower, you need to pay attention to your DTI because it looks at how much you owe in relation to what you make. Let's take a closer look at how it's calculated and why it is so important.

What Is Debt-to-income Ratio, and Why Is It Important?

A debt-to-income ratio is what it sounds like. It's a comparison of your gross monthly income to your monthly debt payments, expressed in a percentage. Your recurring debt payment includes car loan payments, credit cards, and other monthly debt repayments. Your DTI is a snapshot of your current financial wellbeing and your ability to take on new debt. 

Financial institutions use this number to determine your creditworthiness and assess the risks of approving a new loan. Needless to say, lenders like to see a low DTI ratio which demonstrates a good balance between income and debt and your ability to service all monthly mortgage payments effectively. For this reason, borrowers with a high DTI are often considered as a red flag.

Generally speaking, a DTI of 36% or less is considered acceptable to qualify for a conventional mortgage. For a government-backed mortgage, lenders like to see a DTI of no more than 28%. Maintaining a low DTI makes you a better candidate for revolving (such as credit cards) and non-revolving (such as loans) financial products. 

In theory, it might be possible for a borrower with a high DTI to take out a potential loan. However, lenders must adhere to the rules set forth by the Consumer Financial Protection Bureau to determine their loan repayment eligibility. Also, having a high DTI can impact your credit score, especially if you've missed your monthly dues. 

How to Determine Your Debt-to-income Ratio

Sometimes your debt-to-income ratio is combined with your debt-to-limit ratio. But these are two different terms and have distinct metrics for comparison.

A debt-to-limit ratio is a percentage of a borrower's credit utilization rate relative to the total credit availability. Hence the name, credit utilization ratio. In simple words, it's a measure to check if you have maxed out credit cards. 

However, your DTI measures your monthly debt compared to your monthly income, and it can be calculated easily using nothing but basic math.

DTI = (Total monthly debt payment / gross monthly income) x 100

In this formula, your total monthly debt includes mortgage, personal loans, student loans, car loans, credit card payments, and court-mandated payments, if any. 

Your gross monthly income refers to your monthly income before taxes, insurance, social security, and other deductions. If your income varies, you can use your typical month's income as the baseline. 

Tally up your total debts and divide that by your monthly gross income. Multiply that decimal by 100 to get your ratio as a percentage. It's that easy. 

How Do Lenders View Your Debt-to-income Ratio?

• A DTI of 36% or less is considered a healthy balance between monthly income and debt, with no more than 28% of which going toward rent or mortgage. Borrowers falling in this category are marked safe to afford monthly payments for a new loan or line of credit.
• DTI between 36-41% shows manageable monthly debt levels, but lenders may require you to pay off some of your existing debt before approving your new loan.
• DTI of 42-49% suggests dangerous debt levels relative to your income, and borrowers might have difficulty convincing their lender for another line of credit.
• DTI of 50% or more might be viewed as someone struggling to meet their regular payments. Lenders might insist on lowering that ratio or increasing your income.

Further, when applying for a mortgage, lenders look at two types of DTI ratios:

• Front-end ratio: This is your pre-tax income that goes toward monthly housing costs, property taxes, and homeowners' insurance. Lenders prefer to see this under 28%.
• Back-end ratio: This is your monthly pre-tax income that goes toward monthly housing expenses plus any other monthly debt payments such as credit cards, personal loans, medical bills, etc. This does not include household expenses like utilities or groceries. Lenders like to consider the back-end ratio for a more accurate picture of your monthly debt payments. 

How to Improve Your Debt-to-income Ratio?

Let’s see how a DTI ratio of 42% or higher can adversely affect your financial health:

• None to low flexibility within your budget
• Limited eligibility for a home loan, which could be potentially restricting and expensive 
• Less than favorable borrowing terms and conditions with high-interest rates and penalties
• Quick tips to help improve your DTI ratio:
• Pay off your existing debt
• Avoid taking on new and unnecessary debt
• Pay more than the minimum amount on credit cards
• Figure out a budget and stick to it 
• Try raising your monthly income by supplementing it with a side hustle 

Your DTI is just one of the several factors your lender considers, but the lower your ratio, the better off you are. Lower DTI can offer your finances some much-needed balance and stability and bring you that much closer to your desired loan amount. 

Final Thoughts

Your debt-to-income ratio is essentially the measure of your financial security. The higher the number, the lower your chances of securing a loan and clearing your debt. A low DTI will allow you the flexibility to take calculated risks associated with your career change or whatever curveball life throws at you.

Hope this post was helpful, and you'll consider taking the necessary steps to improve your DTI and your overall financial wellbeing. Good luck!!