Your debt-to-income ratio (DTI) is an essential personal finance measure that compares the amount of liability you have with your total income.
Creditors, including mortgage issuers, use it as a way to determine your ability to manage monthly payments and borrowed funds.
Understanding of DTI Ratio
A low debt-to-income ratio indicates a good debt-to-income balance. In general, the lower the percentage, the more likely you’ll get the required loan or line of credit.
In contrast, a high debt-to-income ratio signifies that your income may have too much debt, and lenders consider this a sign that you won’t make additional commitments.
Calculating the debt-to-income ratio
To calculate your debt-to-income (DTI) ratio, add up your monthly recurring debts (such as mortgages, student loans, child support, car loans, and credit card payments) and divide by your total monthly income. (It is the amount you earn each month before paying taxes and other bills).
For example, suppose you pay a monthly mortgage of $1,200, a car of $400, and a remaining debt of $400. Your monthly debt payment is:
$1,200 + $400 + $400 = $2,000
If your total monthly income is $6,000, your debt-to-income ratio will be 33% ($2,000 / $6,000 = 0.33). However, if your total monthly income is less than $5,000, your debt-to-income ratio is 40% ($2,000 / $5,000 = 0.4).
DTI and Getting a Mortgage
When applying for a home mortgage, the lender will consider your financial situation, including your loan history, total monthly income, and down payment amount. To figure out your mortgage affordability, the lender will analyze your debt to income ratio.
Creditors prefer to view a debt-to-income ratio smaller than 36%, with no more than 28% of that debt going towards repaying your mortgages. For example, suppose your total income is $4,000 per month. The maximum monthly payment associated with a 28% mortgage is $1,120 ($4,000 x 0.28 = $1,120).
DTI ratio and Credit Score
Your debt-to-income ratio will not directly affect your credit score. The credit bureau doesn’t know how much cash you earn so they won’t make calculations.
However, the credit bureau will check your credit history or debt ratio and compare all balances in your credit card with the total available credit (the sum of all credit lines on your credit card).
For example, if your total credit card balance is $4,000 and the credit limit is $10,000, your debt-to-credit ratio is 40% ($4,000/ $10,000 = 0.40 or 40%). As a whole, the more an individual owes relative to their credit limit, the lower their creditworthiness will be.
Lowering Debt-to-Income Ratio
There are two alternatives to improve your DTI ratio:
- Reduce your monthly recurring debt
- Increase your total monthly income
Certainly, you can also use a combination of the two. Let’s return to the example where the debt-to-income ratio is 33%. Based on a total monthly debt of $2,000 and a total monthly income of $6,000. If the total monthly current debt is reduced to $1,500, the debt-to-income ratio will correspondingly reduce to 25% ($1,500 / $6,000 = 0.25 or 25%).
Similarly, if debt remains the same as in the first example and we increase the income to $8,000, again the debt-to-income ratio declines ($ 2,000/ $8,000 = 0.25, or 25%).
The other option to improve your debt-to-income ratio value is—reduce your monthly mortgage settlements. It will be helpful to make conscious efforts to avoid debt escalation by focusing on necessities rather than wants when spending.
To increase your income, you can do the following:
- Find a part-time job as a freelancer in your spare time.
- Request for increments and better salary packages
- Work more hours or overtime at your first job
- Take courses or licenses that improve your skills and competitiveness, and obtain a new job with a higher salary