Do you ever feel like your entire paycheck goes straight to loans and other debts? There’s a logical reason for this — your debt-to-income ratio (also known as DTI) is too high.
If your DTI percentage is high, it can make your debt load seem unmanageable. It also impacts other personal finance goals such as going back to school, building credit, or buying your first home.
Find out how to calculate debt-to-income ratio — and how to improve it to get the best deals on loans.
What is debt-to-income ratio?
Your debt-to-income ratio is a simple calculation of how much of your income goes towards debt payments and other financial obligations, such as rent. The lower your debt-to-income ratio, the better your overall financial situation will be.
The exact formula for how to calculate debt-to-income ratio is comprised of dividing the total of all your monthly debt payments by your gross monthly income:
- DTI = total monthly debt payments / gross monthly income
How does DTI affect your finances?
Financial institutions view your debt-to-income ratio as a gauge of your overall financial fitness.
DTI is a measure of your risk as a borrower. The higher your DTI is, the more likely you are to default on a mortgage loan or other debt payment — at least, that’s how the bank sees it. This figure is simply a way for lenders to measure your ability to repay money you’ve borrowed.
Because of this, knowing how to calculate debt-to-income ratio and keeping track of it is extremely important. It could be the deciding factor when you’re trying to get approved for a mortgage or car loan.
One thing to note: A debt-to-income ratio does not have an affect on your credit score directly. While credit bureaus do keep track of your gross income, they don’t use it as part of their calculations.
However, the amount of credit card debt you have in comparison to your credit spending limits (also known as your credit utilization ratio) does have an impact on your credit score. While this is a different topic, it’s important to keep that in mind.
How to calculate debt-to-income ratio
Before further explaining what a good DTI should be, let’s talk about how to calculate your debt-to-income ratio.
Implementing the formula from above, start by adding up your monthly debt obligations. Don’t forget to include your mortgage, home equity loan payments, car loans, student loans, and credit card debt, in addition to any other loans you might have.
Next, add up your total monthly gross income. This includes income from your day job, freelancing, side hustle, weekend gigs, passive income, and any investments.
Once you have both of these figures, your personal debt-to-income ratio is determined by taking your total debt and dividing that by your gross monthly income.
For example, my husband and I have a debt-to-income ratio of 25 percent, which is made up of a pretty large rent payment and a business loan. Neither one of us has student loan debt or car loans, since we paid those off a few years ago. Here’s our personal DTI formula:
Total debt obligations: $2,070
Total gross monthly income: $8,000
Debt-to-income ratio = 2,070 / 8,000 = 25.87 percent
To make it easy, simply add all your information into this calculator:
What is a good debt-to-income ratio?
So what is a good debt-to-income ratio, exactly? It depends on the type of loan you’re applying for.
If you’re in the market for a house, for example, most lenders require a 43 percent or less debt-to-income ratio for mortgage loans to be approved. This number is pretty high, and if you were actually putting over 40 percent of your money towards housing every month, it would likely be very difficult to maintain.
A low debt-to-income ratio is better. This looks more appealing to financial institutions and helps bolster your credit rating. Plus it gives you more cash flow every month. A DTI that’s smaller than 36 percent is advisable, with no more than 28 percent of that going towards housing payments.
In general, paying around 25 percent of your gross income towards debt is much more manageable. So many experts will advise you to aim for 20 to 25 percent DTI when possible. This leaves more money in your pocket for other bills and financial goals. (Hello, retirement fund!)
The bottom line about debt-to-income ratio
Do whatever you can to lower your debt-to-income number as much as possible, and your finances will thank you.
This includes paying down your credit card balances, reducing your housing expenses, and refinancing your student loans when possible. In addition to reducing your debt load, work towards increasing your gross income, as both of these factors will help your DTI.
The lower your ratio, the better you’ll be able to weather any financial emergencies that come your way. It’s a smart move to calculate your personal debt-to-income ratio and take action on reducing that number.
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