What is a Good Debt-to-Income (DTI) Ratio?
Your credit score is the financial variable that gets most of the press when it comes to qualifying for a loan, but there’s another factor that is often even more important: your debt-to-income ratio.
In fact, in a 2014 survey conducted by FICO, 59 percent of mortgage lenders said that a high debt-to-income ratio was their biggest concern when approving loans, compared with just 10 percent who cited a low credit score.
So if you’re hoping to take out a mortgage, or a debt consolidation loan, in the near future, you’ll need to pay close attention to your debt-to-income ratio. Understanding this number and how it affects your ability to get the loan you want will make things a lot easier for you.
This article will help you do just that. You’ll learn what a debt-to-income ratio is, how to calculate it, how it affects your ability to take out different types of loans, and what you can do if your ratio is too high.
What is my debt-to-income ratio?
Your debt-to-income ratio (DTI) measures the amount of your income that goes toward debt each month. It’s calculated by adding up all of your monthly debt payments and dividing that total by your gross monthly income.
It’s an important indicator for lenders choosing which borrowers to approve because a credit score alone simply tells a lender whether you’ve made consistent payments on your past loans. Your debt-to-income ratio, on the other hand, helps lenders determine if you’ll be able to afford all your loan payments once this new debt is added to your existing load.
A low debt-to-income ratio indicates that you should have plenty of room in your budget to pay back the loan. A high debt-to-income ratio indicates that you might struggle to make payments, and therefore could be a default risk.
There are generally two different debt-to-income ratios that lenders look at:
- Front-end ratio: This looks specifically at your housing debt and is calculated by dividing your monthly housing payment by your gross monthly income. This ratio is typically only considered when applying for a mortgage.
- Back-end ratio: This looks at all of your debt and is calculated by dividing your total monthly debt payment — including your housing payment and all other debts — by your gross monthly income. This is the ratio that lenders typically prioritize, no matter which type of loan you seek.
Both are important when applying for a loan, and particularly when applying for a mortgage. Below we’ll talk about maximum percentages that lenders set for both of these ratios when evaluating your loan application.
What is a good debt-to-income ratio?
Shoot for 43 percent or less for mortgages, and 36 percent or less for other types of debt.
In general, lenders prefer that you have a lower debt-to-income ratio since that indicates a stronger ability to afford your monthly payments and stay current on the loan, while also taking care of your necessary living expenses.
A qualified mortgage is one that meets certain requirements designed primarily to protect borrowers from taking out risky loans that they can’t afford, but also provides protections for lenders in order to encourage them to stay within those requirements.
You can potentially get a mortgage with a debt-to-income ratio higher than 43 percent — Fannie Mae will back loans with a debt-to-income ratio all the way up to 50 percent — but it wouldn’t be considered a qualified mortgage and therefore won’t offer the same protections. And because the lender would have to make the loan without the support of the federal government, you may be subject to stricter underwriting requirements in other areas so that the lender can be confident in your ability to repay what you owe.
In addition to that 43 percent cap on the back-end ratio, lenders typically set a maximum front-end ratio of 28-31 percent, and FHA loans cap the front-end ratio at 31-35 percent depending on the specifics of the loan and the borrower’s financial circumstances.
Other types of loans, such as auto and personal loans, do not have strict, regulated debt-to-income ratio requirements. The limits will vary by lender and also by the circumstances of the individual.
How to calculate your debt-to-income ratio
You can easily calculate your DTI by using our LendingTree DTI calculator. It’s simply the sum of all your monthly debt payments divided by your total gross monthly income.
The following things are included on the debt side of the equation:
- Your total monthly housing payment, including your mortgage payment, insurance, taxes, HOA dues, and other amounts put into escrow
- Student loan payments
- Auto loan payments
- Minimum required credit card payments
- Child support
- Any other required monthly debt payments.
On the income side of the equation, you should include all gross income, from before taxes and other deductions are taken out. If you’re paid weekly, you can multiply the gross income from paycheck by 52 and divide that by 12 to get your monthly gross income. If you’re paid every two weeks, you can multiply your gross income by 26 and then divide by 12.
Here’s an example.
Let’s say that you’re paid every two weeks and that your gross income is $2,500 per paycheck. To calculate your gross monthly income, you would multiply $2,500 by 26 to get $65,000, and then divide that by 12 to arrive at a monthly gross income of $5,417.
And let’s say that you also have the following monthly debt payments:
- $1,000 mortgage
- $300 auto loan
- $200 student loans
- $200 credit cards
When you add those monthly payments together, you get a total of $1,700 in monthly debt payments. Divide $1,700 by your $5,417 gross monthly income and you arrive at a debt-to-income ratio of 31 percent. That is, 31 percent of your gross income is going toward debt each month.
That’s the back-end ratio since it includes all of your debt payments. To calculate the front-end ratio, you would simply divide the $1,000 mortgage payment by $5,417 to arrive at 18 percent.
How your debt-to-income ratio affects your credit score
While both your debt-to-income ratio and your credit score are important factors when applying for a loan, they are not directly related.
According to Experian, your debt-to-income ratio is not factored into your credit score. Instead, your credit score relies on a different variable called credit utilization, which measures the amount of debt available to you that you are actually using.
So while many of the same habits that lead to a low debt-to-income ratio will also lead to a good credit score, your debt-to-income ratio does not directly impact your credit score.
How DTI affects lending decisions
Generally, lenders want to be confident that the loans they make will be paid back. After all, when a borrower defaults on a loan, the lender stands to lose both some of the principal it lent out and the income it would have earned from future interest payments.
And your debt-to-income ratio is a key variable that the lender looks at when deciding whether you, as the borrower, will be able to afford the payments and pay the loan back in full.
A low debt-to-income ratio shows that you are a low risk since you have plenty of income available to make all your payments. The lender will be more likely to lend you more money with better terms.
A high debt-to-income ratio shows that you are a high risk since your budget could be stretched thin and you may have trouble making consistent payments. The lender may be less likely to lend you any money at all or might offer a smaller loan amount with less favorable terms.
This is true no matter what type of loan you take out, though the specific requirements will vary by both the type of loan and the lender.
While the mortgage industry has specific guidelines that most lenders will adhere to, other types of loans are less regulated and largely leave the decision in the hands of the lender. Again, though, it’s common for lenders to want to see a debt-to-income ratio of 36 percent or less.
Overcoming a high DTI
A high debt-to-income ratio doesn’t necessarily prevent you from getting a loan, but you may need to do a little extra work to get there.
First, it’s important to start any loan application process with a good, hard look at your budget. Lenders run their own numbers to decide how much they’re willing to lend, but they don’t know how that loan will impact your ability to reach your other financial goals.
For example, you should ask yourself how much debt you can afford without sacrificing your ability to keep food on the table and a roof over your head. And how will this loan affect your ability to do things like save for retirement, save for your child’s education and travel?
Only you can answer those questions, and you should have your answers ready before you ever even speak to a potential lender so that you aren’t led into borrowing more than you can truly afford.
Second, it’s always a good idea to shop around, no matter what your debt-to-income ratio is.
Every lender will look at your situation a little differently, and you may be able to find one who is willing to be a little more lenient with respect to your DTI. Multiple credit inquiries for the same type of loan within a 30-day period count as just a single inquiry.
Third, there are several steps you can take to reduce your debt-to-income ratio and therefore improve your odds of getting the loan:
- Increase your monthly income
- Pay off some of your existing debt
- Make a larger down payment
- Decrease the amount you are trying to borrow
The main thing to keep in mind if you have a high DTI is not necessarily your ability to qualify for a loan, but rather your ability to continue paying your bills and working toward your most important financial goals.
A high debt-to-income ratio might indicate that it’s time to make some changes in your financial life, regardless of your need or desire for a new loan.
The bottom line
Quite simply, your debt-to-income ratio is one of the most important variables to consider when applying for a loan, or when evaluating your overall financial health.
A low debt-to-income ratio is an indicator of good financial health, meaning that you’ll likely have an easier time getting the loan you want and handling the monthly payments.
A high debt-to-income ratio is an indicator of shaky financial health, meaning that it will likely be harder to get the loan you want and afford the monthly payments.
The more you do to keep your debt-to-income ratio low, the easier it will be to manage your entire financial situation.