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Debt to Income Ratio Demystified

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If you’re hoping to get a home loan, auto loan or debt consolidation loan, there’s one important number lenders will want to take a close look at. That number is your debt-to-income ratio (DTI.) Even if your credit report is squeaky clean, your DTI is a good indicator of whether or not you’re overextended and might have trouble with additional monthly debt payments like house or car loans.

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Calculating Your DTI

Your DTI ratio has several components:

The front end ratio is generally composed of housing expenses and includes:

  • Mortgage or rent payment
  • Homeowners insurance
  • Private mortgage insurance (PMI)
  • Property taxes

The back end ratio is composed of the above housing costs plus all other monthly expenses and debt payments including:

  • Minimum payments for credit card debt
  • Auto loan payments
  • Student debt payments
  • Personal loan payments
  • Monthly alimony or child support payments
  • Payments that show on your credit report for other debt
  • The loan payment you are applying for

Both ratios are calculated by dividing your monthly expenses by your monthly gross income.

For example, if your monthly income is $6,000, and you have a housing payment of $1,500, your front-end ratio is 25%. If your other monthly debts total $1,000, the back-end ratio is 41%. You can use our debt-to-income calculator below to arrive at your own DTI.

Lenders use your DTI to determine how well you manage your monthly obligations. The higher your DTI is, the higher the risk lenders feel they are taking on when they loan you money.

Most lenders want to see a front-end ratio of around 28% and a back-end ratio of 36% or less. However, some lenders will approve a loan even with a DTI of 40% to 45%, especially if you can show you are living well within your means. This is where your credit comes into play.

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DTI Ratios and Your Credit Score

While credit bureaus don't look directly at your DTI, the habits that help improve your DTI can also have a positive effect on your credit score. Credit bureaus score your credit based on your repayment of debt and how much of your available credit is being used. For example, if you have two credit cards and a home equity loan giving you access to $80,000 worth of credit, and you are currently carrying $60,000 of that as debt, you may have two issues affecting your credit score.

First, with $60,000 in debt, your credit card and loan payments alone will significantly increase your DTI ratio. Second, having most of your credit tied up as debt can affect your credit utilization ratio.

The credit utilization ratio also accounts for nearly a third of your credit score. If you lower your percentage, you can both boost your score and lower your DTI by reducing your monthly debt.

Don’t Borrow More Than You Can Afford

Your lender is of course aware that you have other expenses, but they won’t take those into account when calculating your DTI. Other monthly bills and financial obligations include things like:

  • Income and other internal revenue taxes
  • Utilities such as water, electricity, gas, cable, internet, and phone service
  • Life and health insurance premiums
  • Healthcare expenses
  • Automotive fuel
  • Childcare
  • Private school costs
  • Groceries and household goods

If you have other significant monthly costs your lender doesn’t know about, they could offer you a loan with monthly payments that may put pressure on your budget even if your DTI seems within acceptable parameters. Qualifying for a $250,000 mortgage doesn’t automatically mean you can afford the monthly mortgage payments.  

What If My DTI Ratio Is Too High?

Remember, requirements for DTI aren’t set in stone. Lenders will also look at your credit score, assets you have like money in savings and checking accounts and what you’re willing to put down on a home loan or auto loan. Certain types of loans, like first-time homebuyer mortgages backed by the federal government or low down payment programs, can accept a DTI that is higher than the normal maximum.

Lowering Your DTI Ratio

The fastest, easiest way to lower your DTI is to make more monthly income or to pay down debt.

Create a monthly budget and be strict about not overspending. Cut out unnecessary purchases and be mindful of where you’re blowing out extra money that could be used for debt repayment.

If you have a large credit card debt on a high limit card, consider transferring your balance to a card with an introductory interest rate of zero for the first 12 to 18 months. This gives you time to pay down your principal debt interest-free.

The Snowball Approach

This method is best if you have a lot of small debts that you can pay off quickly. Arrange your debt by credit balance. Put all of your extra cash each month into paying down this debt until it is paid off, then take the monthly payment you were making plus the extra cash and apply it to the next smallest debt. As you pay off each debt, the available funds you have to put towards the next one increases, creating a snowball effect until you are debt-free.

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The Avalanche Method

This is also called the ladder method and is best if you have some high interest debt and other debt with low interest rates. Pay down balances with the highest rate of interest first, then when it’s paid off move to the debt with the next highest rate of interest.

As you pay off your debt, it can be tempting to take on new lines of credit. Be cautious, as too much open credit, especially newly acquired, is a sign to lenders that you plan to start spending—this can be as damaging to your credit as a high credit utilization ratio. Finally, avoid taking on more debt as it can drive up your DTI ratio and drag down your credit score.

Using your credit responsibly and managing debt sensibly can help you control your DTI ratio and make it easier to get a loan for large purchases when the time comes.  

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