When you apply for a mortgage, car loan, or new credit card, lenders calculate your debt-to-income ratio (DTI) before they approve your application. Your DTI is a measure of your debt load compared to your income. It tells the lender whether you might struggle to afford another payment—like, say, a mortgage—on top of existing debts.
It’s useful for you to know your DTI, too, because it can help you identify whether you need to make changes to your budgeting and spending. The higher your DTI is, the less money you have for other household expenses outside of debt. It’s also a sign that you might have trouble with an unexpected expense and could fall behind on your debt obligations.
How to Calculate Your Debt-to-Income Ratio
Calculating your DTI isn’t hard. It just involves a bit of math and a debt-ratio formula. You can use our Debt-to-Income Ratio Calculator to find yours.
First, add up your monthly debt payments, such as a mortgage, car loan, student loans, and credit cards. These are formal debt agreements that are different from variable expenses like, say, childcare, groceries, or utility bills. While your mortgage is a debt, rent is not and shouldn’t be included in your DTI ratio.
Divide your total debt figure by your gross monthly income to get the ratio (percentage) of debt to income. To find your gross monthly income, divide your gross annual salary by 12.
Here’s how the math works for someone with monthly payments for a car loan, student loan, and credit cards, with an annual gross income of $45,000:
Monthly debts:
- Car: $250/month
- Student loan: $500/month
- Credit cards: $450/month.
- Total: $1,200/month
Annual gross income: $45,000 ÷ 12 = $3,750 gross monthly income
Monthly debt payment ($1,200) ÷ gross monthly income ($3,750) = 32% DTI
Keep in mind, lenders calculate your DTI using your minimum monthly credit card payment, not the total you owe on the card
The Ideal Debt-to-Income Ratio
As a rule, the lower your DTI, the better for you. However, there is no set ideal ratio because if you own a home — a significant debt — your DTI is going to be much higher than if you rent.
However, if you don’t own a home, and you’d like to qualify for a mortgage, it’s a good idea to get your DTI under 40% because anything above 40% could disqualify you from certain mortgage programs (more in a minute).
How Your Debit-to-Income Ratio Affects Your Credit Score
In short, your DTI doesn’t impact your credit score. Your credit utilization ratio might seem related to your DTI, but it’s a different animal. Credit utilization measures how much of your credit limit you’re using. For example, if you spend $6,000 of your $12,000 card limit, you’re using 50% of your credit (the optimum percentage is 30% or less). That’s credit utilization. It’s a factor in your credit score, but it doesn’t affect your DTI, and the two aren’t directly related.
The main reason a high DTI matters is that it indicates you could struggle to meet your debt payments consistently. If you start missing payments, then your credit score will almost certainly take a hit.
How to Reduce Your Debt-to-Income Ratio if It’s High
Really, there are only two ways to reduce your debt-to-income ratio: increase your income or reduce your debt.
If your day job makes for a full schedule, it might be tricky to increase your income, but people do pick up side hustles for additional income.
Reducing debt might be a better option for bringing down your DTI, particularly if you carry a lot of credit card debt. That means reviewing your spending and cutting back where you can.
A third option is to downsize — either your house or your car — to a less expensive choice. Moving house isn’t easy, but it might be worth exploring.
Consolidating your unsecured debts (such as credit cards) can be a way to reduce your monthly payments without having to qualify for a loan. Following a debt management plan, such as MMI’s option, is one way to bring down your monthly payment.
What to Understand About Debt-to-Income Ratio For Seeking a Mortgage
Lenders know, from historical trends, that borrowers with a high DTI tend to struggle to make their payments and are more likely to default on their loans. That’s why lenders often won’t agree to lend to someone with a high DTI — the borrower is too risky to the lender.
If you’re planning on buying a home, assess whether you’d qualify for a mortgage. These loan programs, for example, require specific limits (2022):
- FHA loans allow a maximum DTI of 43%
- USDA loans allow up to 41%
- Conventional loans allow a maximum of 45% but can be as high as 50% under certain circumstances
It’s important to understand the DTI calculation includes the new mortgage payment. For example, to qualify for an FHA loan, your existing debt and your new mortgage payment must not exceed 43% of your gross monthly income.
FHA has another ratio, which is called mortgage payment expense to effective income. It’s a simple calculation: new housing payment (principal, interest, taxes, insurance, mortgage insurance, etc.) divided by gross monthly income. This number cannot exceed 31% to qualify for an FHA loan.
If your DTI is higher than or close to these ratios, you’ll need to make some changes before you can qualify for a mortgage. Reduce your debt, increase your income, or buy a lower-cost house.
What Else to Know
Your DTI is most important when you’re trying to qualify for a loan. It’s not something people necessarily track regularly like their credit score. But it’s still a good idea to periodically review your DTI’s general direction. If it’s increasing over time, that might be a sign that you’re spending more than your income can accommodate, which can quickly become a major problem if unaddressed.
If your DTI is too high to qualify for a loan or has been steadily growing over time, your best bet is reducing your debt ASAP. A debt management plan is one way, but nonprofit experts can help you review all your options. Begin your free analysis online and receive personalized recommendations today.
