Managing finances properly can be difficult, as it is not a straightforward process. However, it is one of the skills you have to acquire to keep your financial profile healthy. Maxing out credit cards and getting into more debt than you can manage can have devastating consequences, so you must be careful.
If you’re looking to get a mortgage or any other type of loan, you might be overwhelmed with the paperwork and information you have to provide. However, this is necessary for the lenders to be able to determine whether you can handle the loan you’re applying for. One of the metrics that help lenders evaluate is your debt-to-income ratio (DTI). Here’s what you need to know about it:
What Is DTI Ratio?
DTI ratio, or debt-to-income ratio, is a ratio comparing your monthly debt expenses and your gross monthly income. In other words, it’s a percentage showing how much of your income you’re using to pay off your monthly debts. The ratio includes debts like car loans, student loans, credit card payments, and personal loans.
Ideally, your DTI will be on the lower end, because that means not a lot of your monthly income is being spent on debt payments. That leaves you with more resources to work with, and that’s hugely beneficial if you want to get approved for a loan.
How to Calculate DTI Ratio
DTI ratio calculations are straightforward and easy. All you have to do is add up all your monthly debt payments and divide the number you get by your monthly income (before taxes). The result will be in decimals, so you’ll get the exact percentage by multiplying it by 100.
As an example, monthly debts of $1,500 with a monthly income of $5,000 would put you at a DTI ratio of 30%. After you make the calculations, you’ll have a better idea of whether you have a chance of being approved for a loan or not. Even though the approval doesn’t only depend on your DTI ratio, it’s undoubtedly one of the deciding factors. If your DTI ratio gets too high, lenders will assume that you won’t be able to manage another loan payment.
What Do Different Levels of DTI Ratio Mean to Lenders
Different lenders have slightly different criteria, but most of them tend to move around the same limits. For example, a debt-to-income ratio of 50% or higher is a sign to the majority of lenders that you have too much debt and that lending to you would be a risk. However, the ideal DTI ratio values fluctuate.
Some lenders consider less than 20% to be the only ideal option, while others are more lenient and allow up to 36%. Many think the area between 37% and 49% is quite risky but can be manageable depending on the exact values. 43% is the highest you can have and still qualify for a loan, depending on other factors. However, the best possible situation you can be in at the end of the month is having some money left after making your monthly payments.
What to Do If Your DTI Ratio Is Too High
A high DTI ratio can bring all sorts of problems, regardless of whether you want to qualify for a new loan or not. When you reserve too much of your monthly income for debt payment, you might end up struggling to pay your bills, or responding to any emergency expenses. Unfortunately, those tend to happen at the worst of times, which is why it’s a good idea to be able to save up for an emergency fund. However, with a high DTI ratio, you won’t be able to save up until you reduce it. Fortunately, DTI ratio itself doesn’t impact your credit score, although they share some metrics which can harm your credit score.
Still, a high DTI ratio can only be temporary, especially if you’re making a push to pay off your debts. In that case, it makes sense to reserve more income going towards those payments for a few months. However, long-term high DTI ratio spells trouble.
You can reduce your DTI ratio by increasing income, reducing debt (by paying it off), or both. A promotion, new part-time job, or even overtime work can make a difference in your DTI ratio. What’s more, getting rid of even one payment by paying off the debt can help you breathe a lot easier. Doing both is ideal, and might free up some financial space for you as well.
What Are the Limitations of DTI Ratio
Even though the DTI ratio is an essential financial metric when it comes to making a credit decision, it’s not the only one that lenders will scrutinize. Other factors play a big part in it as well, such as your credit score and credit history. The credit score is especially important, as it measures your ability to make your debt payments, and a lot of things can impact it — even late payments or delinquencies.
DTI ratios are limited in the sense that they don’t take into account what type of debts you have. It can cause some discrepancies between your total debt outstanding and your DTI when the differences in interest rates on your payments get involved. That’s why lenders include other factors in their decision on whether to lend or not.
A DTI ratio is one of the most crucial metrics of your financial health, so you should keep an eye on it. High DTI ratios mean that you’re reserving a big part of your monthly income for paying different debts, such as car and student loans. It will negatively impact your eligibility for credit, as well as your general finances and ability to respond to emergency expenses.
If your DTI ratio is too high, you can reduce it by either increasing your income, reducing your debt, or both. Doing so will have a positive impact on your financial outlook, which is always a good thing.
Chris Fuller went to the University of South Florida and has worked in the financial sector for over 20 years. He has extensive experience in all aspects of personal and small business lending, from personal loans, equipment finance to cash flow based solutions for small mom and pop businesses, and large corporations.