Understanding How Debt-to-Income Ratio Affects Your Credit Health
- Why DTI isn’t reflected in your credit score
- Understanding the different types of DTI
- Which DTI matters more to lenders?
- Calculating your DTI ratio
- What is a good DTI?
- How can you lower your DTI ratio?
- Buying a home? Keep your DTI low
If you’ve recently applied for a mortgage, personal loan or line of credit, your lender likely considered your debt-to-income (DTI) ratio. This number, written as a percentage, shows lenders how much of your gross monthly income goes toward paying down debt.
DTI doesn’t appear on your credit report, and it doesn’t affect your credit score. But it helps lenders decide if you qualify for a loan and the interest rate you’ll pay. DTI shows lenders how much money you have to pay their loan every month.
Why DTI isn’t reflected in your credit score
Your FICO® Score, a three-digit number ranging from 300 to 850, shows lenders how well you manage credit, which is an indicator of whether you are likely to repay your debt.
Payment history is the biggest factor that makes up your credit score, accounting for 35%. After that are the amounts you owe (sometimes called credit utilization ratio), the length of your credit history, credit mix and any new credit accounts you’ve opened.
DTI is not on this list because it has less to do with how you manage your credit accounts and more about your overall financial health.
Although DTI doesn’t affect your credit score, it is an important factor lenders use to determine your creditworthiness, especially if you are applying for a mortgage, auto loan or personal loan.
Understanding the different types of DTI
There are two types of DTI ratios: front-end ratio and back-end ratio. Together, along with your credit score and your credit reports, these numbers give lenders a better picture of your financial health and your ability to take on additional debt.
The front-end ratio represents the money you spend on housing every month compared with your overall gross income. This is an important number if you are applying for a mortgage.
The back-end ratio compares total debt to total gross income. It tells lenders what percentage of your income goes to debt rather than other monthly expenses, such as utility bills and groceries, or discretionary spending and disposable income.
Which DTI matters more to lenders?
Lenders may look at both front-end and back-end DTI ratios to determine your qualifications for a loan, but they often weigh back-end DTI more heavily.
Back-end DTI gives a more complete picture of your overall financial health and where your money goes each month, which lets lenders know if you will be able to take on more debt and pay it back on time.
Calculating your DTI ratio
Calculating your DTI ratio is easy, but it will take some research. You’ll need to gather all your recent credit card bills, car payment information, other loan payment amounts and mortgage information, along with your monthly gross income.
First, calculate your monthly gross income. Then add all your monthly debt, including credit card minimum payments, car loans, personal loans and student loans. You should also include alimony and child support payments, if applicable. Do not include utilities, groceries or other fixed expenses that do not count as debt.
Add your mortgage payment or, if you are applying for a mortgage, your projected monthly payment, including principal, interest, taxes, home insurance and private mortgage insurance (PMI), if necessary. If you pay any Homeowners Association (HOA) dues, you should include those as well.
To calculate your back-end DTI, add your mortgage debt to your other debt. Then take that number and divide it by your monthly gross income.
Auto loan: $250
Credit card minimum payments: $100
Student loan: $250
Monthly gross income: $5,000
Back-end DTI = 42%
Your front-end DTI is your monthly mortgage payments—including principal, interest, taxes and insurance, or PITI—divided by your monthly gross income, represented as a percentage.
Monthly mortgage payments: $1,500
Monthly gross income: $5,000
Front-end DTI = 30%
What is a good DTI?
If you are shopping for a mortgage, lenders will consider both front-end and back-end DTI. Different lenders have different requirements, so if you are turned down for a loan or mortgage at the first lender you contact, keep looking.
Lenders typically want to see a front-end DTI below 31%, although some may demand 28%. Veterans may qualify for a VA loan with a front-end DTI as high as 41%. Some lenders might even allow a back-end DTI as high as 50% if you have cash reserves or an excellent credit score. If you have a high DTI but additional cash reserves, you may qualify for certain mortgage programs.
How can you lower your DTI ratio?
If you’re applying for a mortgage, it is in your best interest to keep your DTI as low as possible. Not only will this give you access to lower interest rates, but you could qualify for a bigger house in a nicer neighborhood if you can afford a higher monthly mortgage payment.
Fortunately, there are ways to lower your back-end DTI:
Pay off current debt. Your overall credit card debt and minimum monthly payments will decrease over time if you stop using your credit cards and continue paying down the balances. Your credit utilization ratio will also drop, which can ultimately raise your credit score. (If you’re having further troubles, a credit repair service could help, too.)
Reduce your monthly credit card payments. You can negotiate with credit card companies to lower your APR, or consider transferring balances to lower-interest credit cards. Both of these steps can lower your monthly credit card payments, reducing your DTI. You may also consider a debt consolidation loan.
Consider cutting costs. Look at other debts you owe and consider how you can lower your monthly payments. Perhaps you can trade in your vehicle for a lower-cost model with a smaller monthly loan payment, which will immediately reduce your back-end DTI.
Also, think about reducing your discretionary expenses, such as dining, entertainment, cable or gym memberships. Put the money you save toward your credit card bills to reduce your overall debt.
Buying a home? Keep your DTI low
DTI is an important factor when you are applying for a loan. If your DTI is already within the range you’ll need to qualify for a mortgage, make sure not to take on any more debt until your mortgage is approved. To qualify for the best interest rates, it’s a good idea to keep your DTI as low as possible.