What You Need to Know About Debt to Income Ratio

What is debt to income ratio?

The debt to income ratio determines the proportion of debt you have to the amount of income you bring in before taxes. It is an indicator to lenders of whether you can easily meet your monthly debt payments based on your income. Lenders and creditors use this ratio to understand if your income can afford to take on more debt, to ensure that you can repay the debt.

How to calculate debt to income ratio

You can calculate your debt to income ratio in one of two ways. You can divide your total monthly debt payments by your monthly gross income (your income before taxes and other deductions). You can also divide your total amount of existing debts by your total annual income before taxes.

When adding up your income (as well as your partner’s income if you are calculating your household’s DTI), don’t forget other sources in addition to salary and wages. Some of these sources could include pension and retirement benefits, government assistance or child support. On the debt side, you’ll want to include all loan payments, mortgage and property tax payments, and car payments, as well as your monthly rent, and credit card payments.

Why does your debt to income ratio matter?

Your debt to income ratio shows how much debt you have for every dollar you earn. If your ratio is high, it means you owe a lot compared to your income. It could be very difficult for you to get out of debt, save money or even make your minimum monthly payments. A high debt to income ratio could also prevent you from getting approved for other loans or a mortgage.

If your ratio is low, it suggests that you are in good financial shape. Lenders like to see a low debt-to-income ratio as it could mean that you are at lower risk of defaulting on a loan or credit card payments.

Debt to income ratio and credit score

Your debt-to-income ratio may not directly affect your credit score. However, a lower amount of debt as compared to your available credit limits can improve your credit utilization ratio, which may be one of the factors in generating your credit score.

Generally, if you have access to credit but use less than 30% of your current credit limits, your ratio will be low, which could support a healthy credit score. If you use more than 30% of your available credit limit, your credit score may stay lower than it would if you reduced your credit utilization and all else stayed the same.

What is a good debt to income ratio?

The lower your debt to income ratio, the higher your chances will be of meeting your financial goals and paying your bills on time. A ratio in the mid-30s or lower is usually considered ideal, but this is dependent on the creditor or lender. Any higher, and you may be flagged as higher risk, potentially impacting your chance of obtaining an approval for a loan or credit approval.

How to lower your debt to income ratio

You can lower your debt to income ratio in two key ways: You can increase your income, or reduce your debt.

Consider the following ways to increase your income:

• Take on a side job or extra shifts at work
• Work towards a pay raise or promotion at your job

If you can’t increase your income, there are a few different ways to reduce your debt:

• Pay more than your minimum credit card payments to pay off debt more quickly
• Negotiate lower rates with service providers like your phone company