How To Calculate — And Understand The Meaning Of — Your Debt-To-Income (DTI) Ratio

January 12, 2021

“Debt-to-income” (DTI) may sound like a simple relationship on the surface. But not all debt is created equal, and income can be a moving target. Moreover, even if you’re not familiar with the term “debt-to-income ratio,” financial institutions are. Lenders closely examine your DTI ratio when deciding whether to help you finance a major purchase, such as a vehicle or a home.

Read on to learn more about your DTI ratio and why it’s a vital component of your financial health.

What is a DTI ratio?

Your DTI ratio reveals the percentage of your gross — or pre-tax — income that goes toward paying down your debts.

In other words, knowing your DTI ratio allows you to get a better grasp of how much money you owe compared to how much money you earn.

Along with your credit score, your DTI ratio is one of the most significant factors in determining your creditworthiness.

How do I calculate my DTI ratio?

Follow these three steps to calculate your DTI ratio.

Step 1: Add up your recurring (monthly) bills. This category of debt would include your:

  • Rent or mortgage payment.
  • Minimum credit card payments.
  • Auto loan payments.
  • Student loan payments.
  • Personal loan payments.
  • Alimony or child support payments.
  • Any other debt payments that appear on your credit report.

Step 2: Divide the sum of these monthly bills by your gross monthly income. To determine your gross monthly income, divide your annual salary by 12. If you are paid by the hour and do not know your annual salary, you can also determine your gross monthly income by multiplying your wage (or hourly rate) by the hours you work per week. Next, multiply this product by 52 — the number of weeks in a year. Finally, divide that result by 12.

Step 3: Multiply this quotient by 100. Once you have divided the sum of your monthly bills by your gross monthly income, you should have a decimal figure. For example, if your monthly debts total $2,000 and your gross monthly income is $3,120, the result of the above calculation would be 0.64. Multiply that decimal figure by 100 to complete your DTI calculations. In this example, multiplying 0.64 by 100 produces a DTI ratio of 64 percent.

What about my other monthly expenses? Do they affect my DTI ratio?

You do not need to account for certain recurring expenses when calculating your DTI ratio. Among others, these financial obligations include:

  • Most insurance premiums.
  • Groceries.
  • Utilities (electricity, water, etc.).
  • Healthcare costs.
  • Childcare.

Why? Because lenders are most interested in understanding:

  • How much debt you can absorb.
  • How well you can manage your existing debt.
  • How likely you are to pay back any money you borrow from them.

From a lender’s perspective, the expenses listed above provide little to no insight into those questions.

What is an ideal DTI ratio?

Lenders typically consider consumers with higher DTI ratios to be riskier borrowers, as they might not be able to repay their loan in case of financial hardship, such as a job loss.

However, it’s also important to know that, when determining credit risk, different lenders may consult one or more variations of your DTI ratio.

Many mortgage lenders may choose to focus on what’s known as the front-end DTI ratio. A front-end DTI calculation will include only your mortgage payment, property tax obligations, and homeowner’s insurance premiums. Mortgage lenders prefer that front-end DTI ratio to be between 28 to 31 percent — or lower.

Credit card companies, however, may prefer to measure your back-end DTI ratio. A back-end DTI calculation will include the full range of your debt-related payments: auto loans, student loans, monthly credit card payments, and so on.

Many mortgage lenders will also consider your back-end DTI ratio, but they may weigh it differently than your front-end DTI ratio. To secure a qualified mortgage — the most consumer-friendly type of home loan — you should aim to achieve an overall DTI ratio of at least 43 percent. Of course, the lower your DTI ratio, the better.

As all rules of thumb do, this one also comes with exceptions. Nevertheless, federal regulations require lenders to demonstrate that you can repay any home loan they approve. Lenders view a low DTI ratio as reasonable proof that you have the ability to meet any new financial obligations you’ll be assuming.

Does my DTI ratio affect my credit score?

Credit bureaus don’t look at your income when scoring your credit, so your DTI ratio has little bearing on your score. But borrowers who carry a high DTI ratio may also have a high credit utilization rate (CUR). Your CUR accounts for 30 percent of your credit score.

Your CUR measures how much you owe on all your credit accounts within the context of your total amount of revolving credit. This total amount is the sum of all your credit accounts’ borrowing (or spending) limits.

For example, if you have one credit card with a $2,000 credit limit and the balance you owe is $1,000, your CUR is 50 percent. If you have three credit cards, carry a total outstanding balance of $4,000, and have $10,000 in credit available to you, your CUR is 40 percent.

You should try to keep your CUR below 30 percent. You may find it difficult to secure favorable mortgage terms — or a mortgage at all — with a higher CUR.

How can I use my DTI ratio to figure out if I’m carrying too much debt?

Do you have too much debt? Perhaps the better question is, “Do you have more debt than you can handle?” Luckily, you can use your DTI ratio to gain a better understanding of how your indebtedness impacts your overall financial health.

  • If your DTI ratio is less than 36 percent, your debt is likely manageable. You shouldn’t have trouble accessing new lines of credit if needed.
  • If your DTI ratio falls between 36 to 42 percent, some lenders may consider you a moderate risk. Consider paying down what you owe before applying for any new lines of credit.
  • If your DTI ratio falls between 43 to 50 percent, you may face substantial challenges when trying to secure a loan or other form of credit. You may also find that you need to be more aggressive about paying off your debts.
  • If your DTI ratio is over 50 percent, your borrowing options will be very limited. Make paying down your debts a top priority.

How can I improve my DTI ratio?

One way to improve your DTI ratio is to earn more income. But, even if you do win a promotion, secure a raise, or take a second (or third) job, you still need to pay down your debts. And, as we all know, doing so can be easier said than done.

Try implementing one or several of the following best practices to close the gap between what you earn and what you owe.

1) Create a monthly budget. Use a budget to reduce unnecessary purchases so that you’ll have more money left to pay down your debt.

2) Take a strategic approach to debt reduction. Among the most popular methods of reducing debt are the debt snowball and the debt avalanche.

The debt snowball approach involves paying down your smallest credit card balance first. Once you pay off that smallest balance, focus your attention on the next smallest, and continue in this fashion.

Using the debt avalanche approach, you tackle your debt based on interest rates. Concentrate first on paying down the balance that incurs the most interest, then move on to the account that charges the next highest interest rate, and so on.

Whichever approach you take, remember that you must still pay the minimum balance on any credit cards you haven’t identified as your top priority. Neither the debt snowball nor the debt avalanche is a “put all your eggs in one basket” strategy.

Finally, also remember that the key to your success is sticking with whatever strategy you adopt.

3) Make your debt more affordable. Start by calling your credit card companies and seeing if you might qualify for a lower interest rate. You’ll probably have more success with your request if your account is in good standing and you make your monthly payments both regularly and on time.

If you can’t negotiate a better rate with your credit card company, consider transferring one or several high-interest balances to a credit card that charges a lower interest rate. You might also consolidate several high-interest debts into a personal loan that offers a lower interest rate and the convenience of a single monthly payment.

4) Avoid taking on more debt. Getting off the debt treadmill can be tricky. Start by pressing pause on your plans for making any large purchases. If possible, stop using your credit cards and start paying for essentials by cash, check, and debit card.

Although you may feel an initial financial pinch, that’s partly the point. Credit card purchases may be short-term loans, but they still can tempt you to make a purchase and put the cost of doing so both out of sight and out of mind. However, seeing your spending habits for what they are can be a very illuminating — perhaps even life-changing — experience.

Saving with Guaranty Bank & Trust

Along with these suggestions for improving your DTI ratio, we invite you to take five minutes and open a personal checking or savings account with Guaranty Bank & Trust. We’ve designed our bank accounts to help our customers grow, adding features such as low minimum opening balances, attractive interest rates, and other perks to help you manage your money more effectively. Learn more by calling our Customer Care Center at 888-572-9881 or scheduling a video appointment with one of our friendly, caring community bankers today.

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