Debt-to-income (DTI) ratio: What it is and why it matters
Debt-to-income (DTI) ratio is a figure, typically expressed as a percentage, that represents your monthly income after accounting for your monthly debt payments. Some lenders use DTI ratios to evaluate a potential borrower’s ability to repay loans. That means DTI ratios can influence whether lenders approve loans and the interest rates they offer.
What you’ll learn:
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DTI ratio is a snapshot of income in comparison to debt.
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Lenders might use DTI ratio, credit history and other factors to evaluate loan and credit applications.
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Improving your DTI ratio before applying for a loan or credit card could improve your chances of approval.
What is DTI ratio?
Your DTI ratio represents, as a percentage, how much of your monthly income is owed toward debt payments. Lenders use this figure in combination with other information to determine your ability to take on new debt. According to the Consumer Financial Protection Bureau (CFPB), you can calculate your DTI ratio by dividing your total monthly debt payments by your gross monthly income, which is earnings before taxes and deductions are taken out.
Generally, a lower DTI ratio suggests you are more likely to manage and repay debt responsibly.
What are front-end and back-end DTI ratios?
Lenders can evaluate DTI ratios from two perspectives: the front-end ratio and the back-end ratio:
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Front-end ratio: Sometimes called the housing ratio, this ratio expresses what percentage of a borrower’s monthly income is used for housing debt. A front-end ratio could include monthly mortgage payments, homeowners insurance, property taxes and homeowners association dues.
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Back-end ratio: This is the amount of income that goes toward all debts. It can include housing debts, revolving debt like credit card or car payments, student loans, child support and other monthly debts.
Because back-end DTI ratios include all monthly debt, they’re usually higher. And they offer a more complete financial picture. That’s also why when someone refers to a DTI ratio, they probably mean the back-end ratio.
How to calculate debt-to-income ratio
Calculating DTI ratio involves dividing total monthly debt payments by gross monthly income. In formula form, it looks like this: total monthly debts payments ÷ gross monthly income = DTI ratio. Here’s the calculation broken down step by step.
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Add up your monthly debt payments. Imagine you owe $1,200 in rent, $300 in student loans and $500 for other monthly debt payments. That’s $1,200 + $300 + 500 = $2,000 in total monthly debt.
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Calculate your gross monthly income. If you’re a salaried employee, divide your annual salary by 12. For example, if you make $60,000 per year, $60,000 ÷ 12 = $5,000 in gross monthly income. If your income varies from month to month, the CFPB recommends estimating your typical monthly income.
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Divide total monthly debt payments by gross monthly income. Continuing with the example, that would be $2,000 ÷ $5,000 = 0.4
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Convert the decimal to a percentage. You do this by multiplying the value by 100. In the example, that would be 0.4 x 100 = 40%.
Here’s a recap of the math involved in the calculation:
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Total monthly debt payments ÷ gross monthly income = DTI ratio
- $2,000 ÷ $5,000 = 0.4
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Decimal is converted to a percentage.
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0.4 x 100 = 40% DTI ratio
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How to reduce your DTI ratio
Here are few things to consider if you want to reduce your DTI ratio or learn how to use credit wisely:
Pay down existing debt
There are a number of strategies for paying off debt, including the snowball and avalanche methods. Consolidating debt by itself won’t lower your debt, but it could simplify your payments to make it easier to manage. If you could use help, it might be worth exploring professional support through a credit counselor or other source.
Avoid taking on new debt
Taking on more debt without growing your income will increase your DTI ratio. So it can be a good idea to avoid taking on new debt and to apply only for the credit you need.
Pay more than the minimum
The CFPB recommends paying more than the minimum payment on your credit cards whenever possible. This may help you reduce your credit card debt faster and minimize credit card interest charges. It could also help your credit utilization ratio,which can be an important factor in calculating your credit scores.
Use a budget
The CFPB says making and sticking to a budget is an important step toward getting your debt under control. The agency even provides a budget worksheet to help you get started. You might also consider learning more about budgeting with a credit card.
DTI ratio FAQ
Here are commonly asked questions about DTI ratio.
Why is DTI ratio important?
According to the CFPB, lenders use DTI ratio to determine whether borrowers can afford monthly payments and how likely they are to repay the debt. In general, a low DTI ratio could improve your chances of qualifying for new credit and getting the best rates and terms.
What’s a good DTI ratio?
In general, a lower DTI ratio is better. For homeowners, the CFPB suggests keeping your DTI ratio at 36% or lower, including your mortgage payment. The agency also notes that some lenders will go up to 43% or even higher. For renters, the CFPB recommends a DTI ratio of 15%-20%. Rent is not included in this ratio.
Does DTI ratio affect your credit scores?
Your DTI ratio may not directly impact your credit scores. But some factors that influence your DTI ratio can also affect your credit scores. For example, high credit card balances can affect your credit utilization ratio, which can negatively affect your credit scores.
Key takeaways: Debt-to-income ratio
A borrower’s DTI ratio can influence lending decisions. That’s because DTI ratio is one factor that lenders might review to determine how likely someone is to repay their debts.
Keeping your DTI ratio as low as possible could also help you secure better terms for your loans or credit cards. If you want to lower your DTI ratio, you might read these strategies for paying off debt.
