Your debt-to-income (DTI) ratio is a personal finance measure that compares your overall debt to your overall income. To calculate it, the debt-to-income formula is: 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.
Why calculate your DTI ratio
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 a new loan debt.
A higher DTI ratio could be a red flag for lenders because it means you have too much debt for your income. To the lender, this means you may not be as able to meet the additional financial obligations from a new loan. Many lenders, therefore, don’t approve big loans for borrowers with high debt-to-income ratios.
How your debt-to-income ratio affects your loan options
Getting a loan isn’t always as easy as approaching a lending institution, requesting a loan, and receiving immediate approval. The lender wants to know that you have the ability to pay back the loan. So, they are going to look into your financial status, which among other elements, includes:
- Your credit score
- Your credit history
- Debt-to-income ratio (DTI)
Many people are not aware of the impact that their debt-to-income ratio has on their borrowing abilities. This number is an important piece of the financial pie that you need to understand so you aren’t caught off guard when applying for a loan.
A DTI ratio is a part of the loan decision process that may get complicated for a 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 may not offer you the money you need.
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.
How to lower your debt-to-income ratio
Consider the two main components of your debt-to-income ratio: your debt and income. Sometimes just making minimum monthly payments is not going to be enough to lower your debt-to-income ratio in time to reach your financial goals.
If your income stays fixed and your debt remains high, your debt-to-income ratio is going to stay where it is. Whether it’s your monthly debt payments or your income, something may need to change. You may not be able to reduce your debt-to-income ratio overnight, but with a little bit of work over time, you can lower your DTI to a level that is more attractive to lenders.
Consider a few options to swing the pendulum and lower your DTI ratio:
- Pay more than your minimum on monthly debt payments
- Try not to take on more debt than what you already have
- Find ways to increase your income with an alternate side hustle or part-time job
- Keep your budget tight, and make sure you’re calculating your income correctly
- Curb any extra spending
Bottom line: Knowing your DTI ratio gives you peace of mind
It is important for your financial health to keep your debt-to-income ratio as low as possible. With a few minutes and some simple math, you can easily calculate your DTI for yourself before you start shopping for a loan. You can’t plan for the unexpected, but if you know your financial status ahead of time, you may be able to pave the way to a smoother borrowing process.
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