Here’s Why Your Debt-to-Income Ratio is Important

Many people aren’t really sure what a debt-to-income (DTI) ratio is, let alone where theirs stands. In this article, we’ll break it down for you, tell you what a DTI ratio is, how it affects your potential for credit, what is considered a good DTI ratio, how you can get yours, and even ways to improve it.

Understanding your DTI ratio

Your debt-to-income ratio is a financial measurement that compares your monthly debt payments to your monthly income. It’s often used to determine if someone can afford to take on more debt. Lenders will look at your DTI ratio when deciding whether to approve any loan applications and how much to charge you in interest. (Tip: If you don’t know your current DTI ratio, Best Egg Financial Health has a DTI calculator that can help.)

This measurement can be useful for understanding your finances in general. But the question remains: What is a good debt-to-income ratio? Is there a specific number that determines if your DTI is good or bad?

That question is a little tricky to answer. Most lenders look at your DTI ratio as an indicator of your ability to manage debt and make payments on time. A good DTI ratio is one that each unique financial institution considers acceptable. It’s important to know the lender’s criteria for approving a line of credit and to make sure your DTI ratio is within those parameters.

There are 3 general benchmarks identified and accepted by the Consumer Financial Protection Bureau (CFPB) and other specialists that may give you a good idea of a healthy DTI ratio to target.

Those benchmarks are:

• 36% or less: A DTI ratio of 36% or less is a good sign that a manageable portion of your income is being used to pay off your debts. This could indicate a healthy financial situation and may mean you’re a strong candidate for more credit.
• Below 43%: If you have a DTI ratio of less than 43%, you’re probably in a sound condition currently, particularly if you already have a home loan. Creditors usually require candidates for a mortgage to have a DTI of less than 43%. You’re likely in a comfortable spot, but if you’re trying to get a mortgage, you might want to consider ways to decrease your debt.
• 43% or more: If you’re in this DTI range, your monthly payments may be creating a financial burden. The CFPB notes that lenders may be wary of extending new credit when this ratio is exceeded. Fortunately, there are ways to lessen your debt load and pay down debt faster.

Here are a few examples of what DTI ratios look like in real life:

• Your gross monthly income is $4,500, and your monthly housing, credit card debt, auto loan debt, and personal loan debt payments add up to $2,000. This puts your DTI ratio at 44%, meaning certain lenders may decline you for a line of credit at this time. In other cases, you may need to show proof that you can pay off the debt in other ways.
• Your gross monthly income is $2,000, and your monthly credit card and auto loan debt payments add up to $650. This puts your DTI at 32.5%, showing that you’re in a good financial situation in proportion to your income. Therefore, making it a solid chance of being approved for credit.
• Your gross monthly income is $3,500, and you plan to apply for a mortgage soon. Your 2 monthly debt payments for your credit card and auto loan amount to $1,000, giving you a DTI ratio of 28%. You have an excellent chance of getting a loan or credit card based on this ratio.

Knowing your DTI ratio can help prevent unexpected outcomes when you’re applying for credit. It also helps you see a comprehensive overview of your financial situation and can assist you in progressing toward your goals.

Summing up the debt-to-income ratio

When assessing your financial health, your DTI ratio is just one factor to consider. Lenders often will also consider your current credit score, past payment history, and income streams when determining your loan acceptance. Even if your DTI ratio is less than ideal, you can still be financially sound, and vice versa. It’s important to consider your financial standing in relation to your targets. It’s also important to remember that even if your DTI ratio isn’t stellar today, there are ways to improve it.

Paying down debt is the quickest way to improve your DTI ratio. If you need help paying down your debt, the Debt Manager tool at Best Egg Financial Health could help.

Another way to improve your DTI ratio is to increase your income. Asking for and receiving a raise isn’t always easy, but if you have an opportunity and are in line for a pay increase, it’s certainly a good idea to pursue. If not, picking up a side hustle can help boost your income with extra cash. Consider a gig delivering groceries, driving for a ride-share company, or even doing some pet sitting and dog walking. There are endless ways to put your talents and interests to work to make a little extra on the side. Before you know it, your DTI ratio will be in better shape, and you’ll be on your way to a brighter financial future.