Understanding Your Debt-to-Income Ratio

As a borrower, you should always aim to keep the amount of debt in your life at a comfortable level. But it can be tricky to know exactly what that level is. When does your debt begin to negatively impact other parts of your life, such as your ability to take out personal loans or your credit score? Your debt-to-income ratio, also known as your DTI, is an important number that can and does impact these other areas of your financial health.

In this blog, we'll break down what debt-to-income ratio means and how to calculate your own DTI, discuss what a good DTI looks like and why it's so important, and finally, give you some suggestions that can help you get your DTI to where you want it.

What is Your Debt-to-Income Ratio?

A debt-to-income ratio is calculated by dividing the total of all monthly debt payments by gross monthly income. DTI is almost always written as a percentage. Your debt-to-income is an essential factor that lenders use to evaluate whether you're eligible for a loan and that financial institutions analyze to see what kind of financial situation you're currently in.

How do You Calculate Your Debt-to-Income Ratio?

There are many DTI calculators online that can help you find your own DTI percentage if you're wary about calculating these numbers using pencil and paper. However, it's truly not that difficult and these are numbers that you should be familiar with, as they are what you're getting in every month and paying out every month. If you truly want to get a handle on your finances, you should be prepared to know these numbers by heart and get comfortable doing a little math now and then.

Bankrate writes, "To calculate your debt-to-income ratio, add up all of your monthly debts – rent or mortgage payments, student loans, personal loans, auto loans, credit card payments, child support, alimony, etc. – and divide the sum by your monthly income. For example, if your monthly debt equals $2,500 and your gross monthly income is $7,000, your DTI ratio is about 36 percent. (2,500/7,000=0.357)." Bankrate also has a handy DTI calculator.

What is Considered a Good (or Bad) Debt-to-Income Ratio?

NerdWallet states that "a debt-to-income ratio of 20% or less is considered low. The Federal Reserve considers a DTI of 40% or more a sign of financial stress." Lendedu, however, says that the percentage of a good debt-to-income ratio is closer to 36% and below. And the Consumer Financial Protection Bureau advises keeping your DTI no higher than 43%. They say, "The 43 percent debt-to-income ratio is important because, in most cases, that is the highest ratio a borrower can have and still get a qualified mortgage."

A general rule of thumb that you want to keep your DTI less than 40% as 40% is a sign of financial strain. Lenders will look at that number and worry that you're not going to be able to make your payments each month. Another good piece of advice is that lower is better. You want your DTI to be as low as possible so you can stop living paycheck-to-paycheck and start making a dent in your debt or putting away money for the house you want to buy later on down the road.

Why is Your Debt-to-Income Ratio So Important?

Your debt-to-income ratio is so important because it's a key factor that lenders and financial institutions use to evaluate your overall financial health. If your DTI is high, you are less likely to qualify for loans, mortgages, applications for credit, and so on. If your DTI is low, you're seen as a less-risky investment on the part of the bank or lender, and they're more likely to say "yes" to you.

Tips to Lower Your Debt-to-Income Ratio

To lower your DTI, you need to either make more money or reduce the number of monthly payments you owe. If you're thinking, "there's no way I can do either of those things right now," you're not alone. There are still ways you can positively impact your DTI ratio. Try one of the following suggestions:

  • Pay down your debt using a strategic plan. NerdWallet advises using either the debt avalanche or debt snowball method.
  • Put off any large purchases until you have more savings.
  • Find a side hustle that works with your schedule. Side hustles are great ways to make a little extra cash each month. It may not seem like much, but a little extra money coming in can be all you need to improve that debt-to-income ratio.
  • Check out a debt management plan from a nonprofit credit counseling company. You may also want to consider credit card consolidation.

After some time working on getting your debt-to-income ratio right where you want it, be sure to recalculate your percentage. It's a great motivator to see how far you've come and to put your hard work into a real-life context. You're doing the right thing, so keep at it!