There are many different angles from which to examine your financial health — net worth and credit score are two examples that come to mind. Another is debt-to-income (DTI) ratio, a number that’s fairly simple to calculate and very helpful when deciding how to best manage your money.
Here’s more on DTI — how to find it, what it means and what you can learn from it.
How to Calculate Your Debt-to-Income Ratio
The simplest way to think about a debt-to-income ratio is dividing everything you owe by everything you earn — however much you pay toward debt each month divided by your gross monthly income.
Here’s an example: Each month you owe $1,200 on a mortgage, $300 on an auto loan, $300 toward student loans and $250 toward credit cards. Your gross monthly income is around $6,000. Dividing $2,050 by $6,000 and multiplying the result by 100 to get a percentage results in a DTI of approximately 34 percent.
According to Bankrate, here’s what to include in your DTI calculations as far as debts go:
- Rent/mortgage payment
- Minimum balance due on credit cards
- Loan payments (auto, student and/or personal)
- Child support or alimony payments
- Any other types of debt present on a credit report
And, as for income, you’ll want to take your gross income before taxes and monthly deductions.
What Your DTI Says About Your Financial Situation
It’s helpful to keep an eye on your DTI for several reasons, namely that it’s generally correlated with your overall financial health and risk level in the eyes of creditors.
If you’re figuring out how to deal with debt, as so many Americans are, you can use DTI to help you narrow down which solutions might work for your situation. A high DTI may disqualify you from certain courses of action like getting favorable terms on a debt consolidation loan, or getting approved at all. Debt settlement programs — like the one described in these Freedom Debt Relief reviews — on the other hand, are generally more willing to enroll consumers with high DTI ratios.
DTI also plays a central role in becoming a homeowner. As the Consumer Financial Protection Bureau points out, most mortgage lenders will only approve consumers with DTIs under 43 percent for Qualified Mortgages. And these types of mortgages are desirable because they prohibit certain “risky loan features” like interest-only periods, negative amortization and loan terms exceeding 30 years.
You may still be able to qualify for a mortgage with a high DTI, but it will be more challenging to find a lender who’ll agree to loan you the money — and your deal may lack the aforementioned protections. This is because mortgage brokers see high DTI as correlating with a higher chance borrowers will find themselves unable to make their payments.
How to Improve Your DTI
There are two fundamental ways to optimize your DTI: reduce your debts or increase your income. The latter option is not always available, so most consumers focus first on tackling their debts.
As MarketWatch outlines, one strategy is prioritizing whichever of your debts has the highest “bill-to-balance ratio.” This involves calculating what percentage of its total balance each minimum payment is.
Then pay the highest percentages more aggressively. Say Credit Card #1 has a $200 balance and its minimum is $40; Credit Card #2 has a $100 balance and its minimum payment is $50. It would be smarter to pay down #2 faster (the minimum payment is 50 percent of the balance) than #1 (the minimum payment is 20 percent of the balance).
If you’re not sure how to decrease your debt for the sake of improving your DTI, it’s worth making an appointment with a credit counselor to go over your budget.
Your debt-to-income ratio can clue you in to your risk level in the eyes of lenders, which is why it’s important to monitor over time and keep low.