What is a Debt-to-Income Ratio and Why is it Important?

Sometimes life throws a curveball that hits your pocketbook when you least expect it. As a result, you’re forced to shuffle money and make financial adjustments on the fly. Ever wondered what is a debt-to-income ratio? Understanding yours could help you avoid the curveballs.

Borrowing money is often a financially prudent option when you need to fund a large expense and don’t want to deplete your savings. If you have the monthly income to cover the loan expense, then it helps to be able to break those payments up into smaller pieces.

Getting a loan is not quite as simple as walking into a lending institution, requesting a loan, and receiving immediate approval. The lending institution is going to want some guarantee that you have the ability to pay back the loan. So, they are going look into your financial status, most likely looking at three specific elements:

  • credit score
  • credit history
  • debt-to-income ratio (DTI)

You are probably aware of what the first two — credit score and credit history — are, but most people are not aware of what a debt-to-income ratio is or why it matters. This number is an important piece of your financial pie that you need to understand so you aren’t caught off guard when applying for a loan in a financial pinch.

Here is what you need to know.

What is a Debt-to-Income Ratio and Why Does It Matter?

Your debt-to-income (DTI) ratio is a personal finance measure that compares your overall debt to your overall income. To calculate it, simply divide your recurring monthly debt payments by your monthly gross income. The number is expressed as a percentage.

Lenders use this percentage to assess your ability to manage monthly payments and repay the money you want to borrow from them. Ultimately, it helps lenders determine how much money they are willing to lend you.

The lower your debt-to-income ratio, the more likely you are to receive the loan amount you want because your low DTI ratio illustrates a good balance between debt and income (i.e. that you don’t spend more than you can afford). Low DTI numbers typically indicate to lenders that you, as a borrower, are more likely to successfully manage your monthly payments with new loan debt.

A higher DTI ratio is a red flag for lenders because it means you have too much debt for your income. To the lender, this means you will be less likely to meet the additional financial obligations from an additional loan. Lenders, therefore, tend not to approve big loans for borrowers with high debt-to-income ratios.

This is the part of the loan-approval process that can get complicated for the borrower. The amount you request may not be the amount you get approved for because your debt-to-income ratio is too high, and the lender is unwilling to loan you money above a certain threshold.

If you fall into the high-DTI category, you may not be able to get the loan amount you need to finance your unexpected expenses, and you may have to dip into your savings.

It Will Matter When You Need It

It is important for your financial health to keep your debt-to-income ratio as low as possible at all times. With a few minutes and some simple math, you can easily calculate this number for yourself before you start shopping for a loan. You can’t plan for the unexpected, but knowing ahead of time your financial status, plus any obstacles to borrowing you may face, can pave the way for a smoother borrowing process.

If you need to calculate your DTI visit Nerd Wallet for a DTI calculator.