Mastering your finances: The importance of knowing your debt-to-income ratio

When you apply for a loan or a new line of credit, one of the things lenders and creditors look at is your debt-to-income ratio (DTI). Learn why your DTI matters, how to calculate it and how to improve it if necessary.

Your DTI is the percentage of your gross monthly income that goes toward paying your debts. Lenders look at this number to determine how capable you are of repaying a loan. Your DTI is important for your personal finances because if your DTI is too high, it could be difficult for you to get a new loan approval, or you could end up paying higher loan interest rates.

Your DTI is determined by dividing the sum of all your monthly debt payments by your total gross monthly income (your income before taxes).

Common Debts

• Monthly mortgage or rent payment
• Homeowners insurance
• Credit card payments
• Loan payments (student, auto and personal)
• Alimony and child support payments

Income Sources

• Monthly wages/salaries
• Pensions
• Social Security
• Alimony and child support
• Any other additional monthly income

Lenders might look at two different types of DTI: front-end and back-end. Your front-end DTI includes housing-related expenses only (mortgage/rent, property taxes homeowners insurance and homeowner’s association dues), while your back-end DTI encompasses all remaining monthly debts (credit cards/loans).

Your front-end DTI isn’t a huge factor for lenders, but it will give you a bigger picture of your financial health and a better idea of what you can afford. Your back-end DTI is what lenders focus on because it provides a more comprehensive picture of your monthly spending.

Tip:  When calculating monthly debts for your DTI, do not include monthly utility bills, health and auto insurance premiums, retirement account contributions or entertainment, food and clothing costs.

Understanding your DTI

What’s considered a good DTI? Lenders consider a DTI of 36% or less to be favorable. It shows that your debt is at a manageable level and will play a key role in being approved for a new credit line or loan. But what if your DTI is higher than 36%? What level of debt do lenders consider too high?

• 37% to 42% DTI:  A ratio within this range does show lenders that you are able to adequately manage debt. However, a lender may find a DTI ratio within this range to be somewhat concerning and could be reluctant to let you borrow money – or they might charge you higher loan interest rates.
• 43% to 50% DTI:  With almost half of your monthly income going to monthly debt payments, this level of debt may be challenging to manage, and may limit your lending options.
• 51% or higher DTI:  With more than half of your monthly income being used to make your minimum monthly debt payments your ability to borrow or get new credit is very unlikely, and lenders will view your chances of being able to make your monthly payment on any new debt as difficult or unlikely.

Three ways to improve your DTI

Whether it’s the result of making common money mistakes or not fully understanding credit basics, a high DTI doesn’t have to last forever. If your DTI isn’t what you’d like it to be, there are a few things you can do to improve it.

1. Reduce your debt payments.

Paying off some of your debt will lower your DTI. If you can pay off your smallest debt in full, that will immediately improve your DTI ratio. If you can’t pay your debt in full, making more than your minimum monthly payments will enable you to pay down your debt and lower your DTI faster.

2. Consolidate debt or refinance loans.

Since your DTI is based on your monthly debt payments, consolidating debt or refinancing loans could help you lower your monthly payment, which would also lower your DTI. If credit card debt is a big part of your overall debt, consider ways to consolidate your credit card debt including balance transfers and unsecured personal loans.

3. Increase your income.

Try negotiating a raise with your employer, freelancing, adding a side hustle or picking up a part-time job. If you can show lenders the income is recurring and continuous, it should improve your DTI.

You can also make some lifestyle changes that could positively impact your DTI, like downsizing to a less expensive home or car.

Calculating, understanding and improving your debt-to-income ratio is an important part of your financial health. By uncovering your DTI and taking steps to lower it, you’ll be taking a huge step in improving your personal finances and will be more likely to qualify for new credit or a loan.