We all know that it is important to make more money than we spend. That’s just basic economics. If you want to stay in the black, then you have to keep your spending in check.
However, in real life, I know how complicated it gets. We have bills, car payments, mortgages and credit cards. Capitalism has evolved to rely heavily on debt, and it is not uncommon for the average American to carry their share.
How much debt is okay? When is a little debt too much? To answer these questions and understand the reality of your debt, we need to examine the debt-to-income ratio.
Understanding the Debt-to-income Ratio
The debt-to-income ratio is a measurement that looks at the entirety of your monthly debt payments.
This debt total is then divided by your gross monthly income.
By dividing these two figures, you come up with a percentage. This is the figure known as your debt-to-income ratio. It is commonly referred to as DTI. DTI is a useful figure to understand your financial situation, and it can have implications for your ability to take out loans.
Calculate Your DTI Ratio
To calculate your DTI, you need two things.
First, you need your gross monthly income. This number is the amount of money you make each month before taxes and other deductions.
Second, gather up your bills. You will need to look at all the payments you make each month. This can include the following.
- Student loans
- Automobile loans
- Child support
- Credit card payments
- Personal loans
- Any regular payment
After you add up all your payments each month, divide that number by the amount you make. This will result in your DTI.
Examples of DTI Calculation
To understand the idea better, I think it’s best to look at an example.
Let’s say you make $6,000 a month in gross income.
As for your monthly payments, we’ll say that you have a mortgage payment of $1,000. Pretend your car payment is $200, and you have a minimum credit card payment of $200 as well. Throw in a student loan payment of $100, and add up your total for $1,500 a month.
Take the payment total of $1,500, and divide it by your gross income of $6,000. The end result is 0.25. This means that your DTI is 25 percent.
Let’s look at another example. We’ll say that your gross income is $5,000 each month. However, you have a rent payment of $1,200, a credit card payment of $300, a car payment of $500 and personal loans of $500.
This means your payments each month total $2,500. When you divide that number by your $5,000 gross pay, you get 0.5. In other words, your DTI is 50 percent.
The Impact of DTI on Your Life
Once you know your DTI, you have to understand its impact on your life.
Many people never know about their DTI until they take out their first loan.
Lenders usually look at DTI in order to determine a borrower’s loan viability.
If you have a high debt-to-income ratio, then you may discover that you are not eligible for the same loans as others. On top of that, understanding your personal DTI can help you better grasp your own financial situation. Your DTI should be a factor in determining how you spend your money each month, and it can be a sign that financial changes are needed.
Lenders and DTI
Lenders are the primary reason DTI measurements exist.
Lenders will use DTI to assess loan candidates.
If an applicant has a low DTI percentage, then they are considered to be low risk.
However, if the applicant has a higher DTI, then they may be high risk. Some lenders will reject loan applicants based on their DTI score. Every lender has their own threshold for the DTI metric, but industry experts generally say that a DTI under 43 percent is preferable.
The reason for this logic is pretty easy to see. Imagine that you have a high DTI ratio. That means you are spending around half or more than half of your paycheck each month making payments. When so much money is allocated to payments, there are fewer liquid assets in case of emergency. If unexpected expenses arise, there is little wiggle room in the budget for these borrowers.
Differences Between Lenders
It is important to note different types of loans usually have different DTI thresholds.
A large mortgage company is going to have a lower tolerance for DTI percentages.
Smaller creditors may agree to Qualified Mortgages for borrowers in these situations. A Qualified Mortgage allows borrowers with a higher DTI to take out a loan with certain stipulations.
Also, a personal lender will usually have more lenient criteria for the DTI ratio. This is why personal loans are an excellent vehicle for borrowers. Even if you have a spotty financial history, a personal loan can help you stay afloat.
DTI and Credit Scores
Your DTI ratio is very important, but it is not directly related to your credit score.
A credit score is also a way to look at your probability of paying your bills on time.
However, a credit score assesses the number of loans you have and how well you have fulfilled your obligation to those loans. A credit score does not consider your income. Some people can have a high DTI ratio and still have excellent credit. It is also possible to have a low DTI ratio and almost no credit whatsoever.
The ratio that does impact your credit score is the credit utilization ratio. This ratio looks at how much credit you use compared to your credit limit. A lot of experts recommend having a credit balance of 30 percent. For example, if your credit limit is $10,000, you should only carry a monthly balance of $3,000.
As a general rule, if your DTI ratio is less than 36 percent, then it is considered low.
Most lenders will not raise any red flags for a DTI below 36 percent.
At this ratio, you should have easy access to any line of credit you seek. Your DTI ratio will not hinder you from getting a mortgage, auto loan or personal loan. A DTI ratio under 20 percent is extremely low, and it shows that you have managed your debt very well in comparison to your income.
With a low DTI ratio, the key is to keep doing the right steps. Your DTI ratio can change as your financial situation changes. A low DTI ratio must be maintained with studious loan repayment.
There is a small window of moderate DTI that ranges between 36 and 42 percent.
At this level, your debt-to-income ratio will give lenders some pause.
A DTI ratio in this range can make it difficult to get a loan in some cases.
Therefore, if your DTI ratio falls in this range, it is probably best to take action. It is a good idea to pay down some of your debt. Since your DTI ratio is still at a moderate level, your debt can probably be managed with a few easy steps. A moderate DTI ratio can be reduced quickly with effective financial changes.
However, it is worth noting that a moderate DTI ratio can also get worse quite rapidly. You have to be aware of your finances in order to prevent a worsening situation with your debt.
Anything above 43 percent DTI is considered high.
A DTI of more than 50 percent will be very hard to deal with over time.
Once you reach a DTI ratio of 43 percent, you will have a hard time getting approved for a loan. You may also be denied other lines of credit. Some lenders will work with you for a Qualified Loan, but many restrictions apply.
If your DTI exceeds 50 percent, then it is time to start looking at corrective measures. You will need to enact a debt-reduction plan.
When to Manage Your Debt-to-income Ratio
If your DTI ratio is 36 percent or higher, then you should consider taking action.
A DTI ratio above 43 percent must be addressed for long-term financial stability.
There are several measures you can take. I think it’s useful to remember that managing your DTI ratio is about lowering the amount of debt you have or increasing the amount of money you make. To tackle serious problems, you may need to embrace both angles.
Debt-to-income Reduction Ideas
- Extra payments: If you have room in your budget, reallocate some funds toward debt payments. If you can make extra payments on your debt, you will lower your debt levels at a more rapid rate. Some people can make this shift by cutting out other lifestyle expenditures.
- Avoid more debt: In particular, try to keep a lid on your credit card usage. I know how tempting it can be to charge things, but credit card debt can be crippling and difficult to overcome. Charging more will not get you out of your debt hole.
- Postpone large purchases: If you are in debt reduction mode, then you should not be thinking about big purchases. If possible, this is not the time to buy new houses, fancy phones or new cars. Avoid expensive vacations and other sizeable investments until your debt is under control.
- Take out a personal loan: I know this seems like a contradiction, but personal loans can play a critical role in reducing a serious debt load. If you are struggling to pay back your bills each month, you can take out a debt loan. Personal lenders often have less stringent lending criteria, and you can consolidate your payments with a debt loan. With this approach, you are only paying a single bill each month. This makes your debt easier to manage.
Ultimately, your debt-to-income ratio is an important factor when taking out a loan.
More vitally, your debt-to-income ratio is a sign of your financial stability.
How are you dealing with your DTI ratio? What measures have helped you manage your debt? Let us know your thoughts in the comments.