When you apply for a mortgage, car loan or credit card, lenders consider multiple factors such as your credit score and debt-to-income ratio. Your credit score is a three-digit number that reflects your history of paying back your debts. Your debt-to-income ratio (DTI), however, is a reflection of how you’re currently managing your debt and income. Your DTI compares the monthly debt payments you owe to your monthly income. Together, these factors help lenders understand the risk you may pose as a borrower.
By understanding what debt-to-income ratio is and how it’s calculated, you can prepare your finances to shop for a house or other big purchase.
How to calculate debt-to-income ratio
To get your DTI, take all your monthly debt payments and divide that number by your gross monthly income, which is your income before any deductions like taxes and insurance premiums. Debts may include a mortgage, car loan, student loan and the minimum balance on a credit card. It does not include rent or monthly bills like utilities or subscriptions.
For example, if a person has a monthly car payment of $400, student loan payments of $250 and minimum monthly payments of $100 on their credit card accounts, their monthly debt payment total is $750. If their gross monthly income is $5,000, dividing $750 by 5000 would provide a DTI of 15%.
What’s a good debt-to-income ratio?
To increase your chances of being approved for a loan, lenders generally like to see your DTI around 35% or lower. Of course, the lower the better. A low DTI can show you have enough room in your monthly budget to handle additional debt payments. What is considered a “good” DTI can vary between lenders and the type of loan for which you’re applying.
If you’re applying for a mortgage, in addition to the more conventional DTI, your lender may also analyze what’s called a front-end ratio. The calculation of a front-end ratio is similar to that of DTI, but a front-end ratio tends to only include potential housing costs like your mortgage payment, property taxes and insurance. It would not include other debts you may have like a car or personal loan.
To find your front-end ratio, add up costs related to your regular mortgage payments and divide by your gross income. For example, if your total mortgage payment of $1,700 (including escrowed taxes and home insurance) is divided by a gross monthly income of $5,000, your front-end ratio would be 34%.
The types of income and debt lenders include in their DTI calculations can vary. If you’re working with a lender, make sure to ask how they measure DTI so you can have a clear understanding of how to improve your odds of approval.
When is debt-to-income ratio used?
Your DTI can be considered by lenders for a variety of loans, including credit cards, auto loans and mortgages, to name a few. A high DTI may indicate your debt load is too high and it would be risky to lend you additional money. The lower your DTI, the more likely it is you’ll be seen as an eligible borrower and can generally expect better loan terms, like lower interest rates.
Does my debt-to-income ratio affect my credit score?
Your DTI ratio isn’t used in credit score calculations. However, aspects of your credit health can be intertwined with your DTI.
For example, carrying large balances on your credit card accounts can have a negative impact on your credit score, since your credit utilization rate is an important credit score factor. At the same time, if those high balances cause your minimum monthly payments to increase, this could impact your DTI. In short: Your personal finances and credit health are closely related, but your DTI doesn’t directly impact your credit heath.
It’s smart to prepare your credit for mortgages, auto loans and other major purchases so you and lenders are confident in your financial standing. To improve your DTI, paying down debt as efficiently as possible can go a long way.
But that doesn’t mean you have to ignore building your savings. It’s a good rule of thumb to have money saved up for emergencies. Plus, some home loans have down payment requirements you need to be prepared for. Planning large purchases is about finding the right balance so your DTI is manageable and you have enough money on hand for whatever life throws your way. You can learn more money management tips from our blog on how to pay off debt and save money at the same time.