Personal Finance | December 21, 2022 | Prima Bhakyapaibul
What debt-to-income ratio means and why it’s important
What you'll learn
- What debt-to-income ratio is and why it’s important
- How to calculate debt-to-income ratio
- Techniques for paying off debt
The key to borrowing money is showing lenders you’ll be able to pay it back. Your debt-to-income (DTI) ratio is one measurement lenders use to evaluate your ability to repay the loan you’re taking out. According to Investopedia, lenders will usually look for a DTI of 36% or less to consider you a qualified borrower. This means that 36% of your gross income (your income before taxes and other deductions) goes toward debt payments every month.
The higher the percentage, the more debt you have. This can signal to lenders that you may be borrowing more than you can handle financially—that your debt is eating up too much of your income each month. Calculating your DTI ratio can also help you make a smarter plan to pay off your debt faster.
How to calculate debt-to-income ratio
DTI ratio is simply your total monthly debts divided by your gross monthly income, multiplied by 100 to get a percentage.
Let’s say you pay $500 a month for student loans, $200 a month for credit card debt, and $300 for other personal loans, your total monthly debt payment is $1,000. If your gross monthly income is $5,000, just take the $1,000 in monthly payments and divide it by $5,000 to get 0.2. When you multiply that by 100, you get a DTI ratio of 20%. This DTI ratio is below 36%, which could generally qualify you as a reliable borrower.
Example of total monthly debt payments:
$500 + $200 + $300 = $1,000
DTI ratio calculation:
$1000 (monthly debt) $5,000 (gross monthly income) = 0.2
0.2 100 = 20% (DTI ratio)
What you can do to lower your DTI rate
If your DTI ratio is over the benchmark for a loan you’re applying for, there are several things you can do:
1. Understand what your level of debt is by using a debt-to-income calculator, like this one from Bankrate.com. https://www.bankrate.com/mortgages/ratio-debt-calculator/
2. If your finances allow it, try to adjust your payments. If your income remains the same and you need to lower your DTI rate for a new loan, paying off some debt will lower your DTI rate. Using the same example as above, let’s say the $300 for your personal loans are a priority to pay off. Then you’re left with $500 in student loan debt and $200 in credit card debt, which is a total of $700 in monthly debt. $700 divided by $5,000 is 0.14, which is equal to 14%. As a result, now that you’ve paid off some of your debt, your DTI ratio is significantly lower. Your DTI ratio will also be lower if your debt remains the same but your income increases.
3. Avoid adding more debt in the near future, if you can. Or postpone large purchases until your financial situation improves.
Paying off debt involves more than just a simple calculation. With interest rates adding more debt on some loans, like student loans, calculating your repayment amount can be complicated. Plan your loan payments: if you have student loans, exploring your repayment options and using a student loan payment estimator is a good place to start.