What is debt-to-income ratio and how does it affect you?

Miami Herald

4 days ago

You don't need a finance degree to have money smarts. Understanding a few simple terms can help you lead your best financial life. One of those terms is DTI, or debt-to-income ratio. It's an important concept because lenders use DTI to determine whether you can afford the loan you want. Achieve says understanding your DTI can give you an important edge when you're looking for a home equity loan or another kind of loan.
Definition of DTI (debt-to-income ratio)
DTI, or debt-to-income ratio, is the percentage of income you spend on your debts and housing each month. DTI doesn't consider the total amount of debt you have. Just how much you have to pay each month.
How to calculate DTI
To calculate DTI, add up your housing payment and the minimum payments on all your debts. Divide the total by your total income. If your income is $5,000 per month, and your debt and housing payments total $2,500 per month, divide $2,500 by $5,000.
2,500 ÷ 5,000 = 0.5 (50%)
There are a few rules:
The income you'll use is your total before-tax income, not your take-home pay. To be counted, income must be ongoing and reliable.Don't include every bill. General living expenses like food, income taxes, utilities, fuel, and childcare don't count toward your DTI.Do include the minimum payments on your credit cards.Don't include extra-but optional-payments you make toward your debts.Do include housing costs. If you rent, it's your rent. If you own, it's your mortgage payment, including principal, interest, taxes, insurance, and HOA dues.Do include the required monthly payments on your loans. Include car loans, personal loans, student loans, and other debts you're paying off. If you are legally obligated to pay child support or spousal support, include those as well (but the lender might not consider these payments if they're due to end soon).
DTI and your credit score
DTI doesn't affect your credit score, and your credit score doesn't influence your DTI. Your credit score is based on:
Your payment historyAmounts owedAccount ageCredit mixHard inquiries (the kind that happen when you apply for credit)
That said, both DTI and credit score are measures of financial health, and they often go hand in hand.
For example, if your credit card balances are high and you can only afford to make minimum payments, chances are good that your credit score has taken a hit and you have a high DTI.
On the flip side, if you have a low DTI, that could mean that you are living below your means and avoiding excessive debt. It would be great if these qualities were rewarded with high credit scores, but they aren't. To have good credit, you need to have and use credit accounts. If you avoid debt, you might not even have a credit score, even with a great DTI.
Here are a few examples of DTI calculations.
DTI with a personal loan
Dan and Lucy earn $8,000 per month between them. Their rent is $2,000. The minimum payments on their credit cards total $300 per month, and they have a $300 monthly car payment. They need $10,000 to cover medical expenses, so they're applying for a personal loan together. The loan will have a $200 monthly payment.
Here's how the lender calculates their DTI:
Most lenders will approve a loan at a 35% DTI, assuming the applicants meet their other requirements.
DTI with a home equity loan
Luke earns $78,000 a year ($6,500 per month) and owns his home. His mortgage payment includes $1,100 for principal and interest, plus $140 for property taxes and $60 for homeowner's insurance (total payment: $1,300). He also has a $300 car payment. Luke wants a $100,000 20-year home equity loan for some renovations. He qualifies for an 11.5% APR. The monthly payment will be $1,078.
This home equity loan example is for informational purposes only. The payment is calculated using the Actual 360 interest calculation method. Interest rate and payments are for illustration only. Individual results vary.
Here's Luke's DTI:
Most home equity lenders will consider Luke's DTI to be within the acceptable range to qualify for a new loan.
DTI for a debt consolidation loan
Chantal earns $5,000 per month, pays $1,500 in rent, and owes $25,000 in credit card debt. Her credit card APRs range from 24.99% to 28.99%. Her total monthly credit card payments are $812. Beforeborrowing, Chantal's DTI is:
For many people, a 46% DTI is too high to live comfortably. Spending that much of your income on housing and debt leaves little for taxes, utilities, food, healthcare, household expenses, savings, or fun.
But what if Chantal gets a $25,000 personal loan to consolidate her credit card debt?
If she qualifies for a 17% interest rate and opts for a five-year term, her payment drops to $621.
After she uses a loan to consolidate her credit card debt, Chantal's credit card balances are zeroed out and the $812 in credit card payments goes away. The new loan payment is $621. Chantal's expenses total $2,121 and her DTI drops to 42%. Now she has nearly $200 worth of additional breathing room in her budget every month. This DTI gives her a little more flexibility to cover life's other expenses.
Why is DTI important?
DTI isn't just important to lenders. It matters even more to you. Your DTI is a snapshot of how doable your lifestyle is at any given time.
What is a low DTI?
Most lenders consider 36% or lower to be very healthy, and of course, lower is always better.
When you apply for a loan, lenders love a low DTI because it shows that there's money in your budget that could cover a new loan payment. That's why having a lower DTI could improve your chances for loan approval. In some situations, a low DTI could help you land a lower interest rate on the loan you want.
A low DTI isn't just about loan applications, though. It's about managing your budget. Having a low DTI makes it easier to afford your current financial obligations, with money left over for household expenses, savings, unexpected costs, and some fun.
What is a high DTI?
Anything over 43% is considered high-ish. It's a limit established by many mainstream lenders. However, people get loans with a DTI over 43%, and even over 50%, every day. It depends on the overall strength of your finances and the type of loan you're after.
A high DTI could make it harder to borrow when you need to. Or it could make it harder to borrow the amount you want. Mainly because to the lender, it looks like you might not be able to afford the payment.
A higher DTI could also lead to more expensive loans. That's because a higher DTI represents a higher risk to the lender, so they might charge more to compensate for the risk. If you have a high DTI, the lender may ask for other evidence of financial stability before approving your loan.
The world won't end if your DTI is on the high side, but it's something to watch, and something you'll probably want to work on. Even if you're not planning to apply for new credit any time soon, a high DTI means most of your money is already spoken for. That leaves you less to save, invest, and spend on the necessities of life. Bringing your DTI down means making more of your money available to spend or save the way you choose to.
DTI and home loans
Mortgage lenders, including home equity lenders, look closely at your DTI when you borrow. In the past, many lenders set 43% as a cut-off for mortgage approval. However, not every lender or loan program applies this limit today. In fact, some home equity loan lenders will consider your application even if your DTI is as high as 50%. Loan eligibility is typically based on multiple factors, including your credit score and the reason you want the loan.
If your DTI is higher than 43%, the best thing to do is talk to a mortgage advisor who can help you learn about your options.
DTI and personal loans
The way personal loans work is ultimately up to each lender that offers them. Providers vary widely in what DTIs they're willing to accept. The typical maximum is 35% to 43%. DTI is just one part of your application. The lender will evaluate your income, your credit standing, the reason you need a loan, and other factors.
Keep in mind that DTI isn't about how much money you make or how much debt you have. The focus is on how your monthly income and expenses relate to one another.
For example, let's say Alex applies for a personal loan. Alex makes good money and isn't concerned about getting approved for the loan. Here is Alex's debt and income breakdown:
A personal loan lender might decline to offer Alex a loan, because any new payment looks unaffordable. If Alex can afford it, a great way to lower DTI would be to pay down (or pay off) the credit card debt and eliminate that expense.
Getting rid of the credit card expense would bring Alex's DTI down to under 38%.
Tips for improving DTI and increasing loan eligibility
There are several ways to improve your DTI. Generally, they fall into one of these three categories:
Lower your monthly debt payment by consolidating or refinancing your debtsPay down your debtIncrease your income
Debt consolidation:The way debt consolidation works is that you take one new loan and use it to pay off more than one smaller debt. This could lower your DTI if the consolidation loan has a lower payment than the loans it replaces. You could reduce what you pay each month if you get a loan with a lower interest rate and/or a longer repayment term. Debt consolidation doesn't get rid of any of your debts. It only moves your debt from one place to another.
Debt refinancing: Refinancing a loan means replacing it with a new one. People do this when the new loan has a lower interest rate, lower payments, or some other benefit. If your new loan has a lower payment, this reduces your DTI.
Increase your income: A great way to reduce DTI is to offset your debt expenses with more income. More income could ease financial stress, too. Consider picking up another job or exploring other ways to generate more income.
Pay down debt: This is your long-haul plan. You can improve your DTI without taking on a new loan. Get a budget together and set some goals. To pay off your balances over time, you'll need to be mindful about spending. Once you've got your plan in place, make it stick. Check your balances and DTI every month. Do your best to stay on track and don't forget to celebrate your progress.
At the end of the day, DTI is a measure of your financial comfort level. If your DTI is on the high side, consider the goals you could work toward if you had more money at your discretion each month. Setting your sights on specific priorities could help motivate you to work toward a lower DTI.
Frequently asked questions
What does a DTI do?
DTI is a calculation. It's your monthly housing and debt payments divided by your monthly pre-tax income. DTI shows how much of your income you spend on housing and required payments. DTI also shows lenders if you can afford a new payment when you apply for a loan.
What DTI ratio is good?
A DTI under 36% is considered healthy and low. Most lenders allow DTIs up to 43% for most kinds of loans. Many mortgage loans allow a DTI above 50%, but it's not as common for unsecured loans.
Is 50% DTI too high?
A DTI above 50% is common, especially in areas where housing is expensive, but it's hard. Spending half of your pretax income on housing and debt service doesn't leave you a lot of wiggle room. The rest of your income has to cover income taxes, food, utilities, transportation, school costs, hobbies, household goods, clothing, and anything else. That said, some people manage at a 50% DTI by being ruthless with their budgets. Consider targeting a lower DTI over time to make your life more comfortable and secure.
This story was produced by Achieve and reviewed and distributed by Stacker.
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