Takeaways
- Your debt-to-income ratio is a proxy for your ability to service debt.
- Based on the type of debt, lenders have different debt-to-income requirements
- A low debt-to-income ratio indicates that you have sufficient cash flow to service a debt.
- A high debt-to-income ratio indicates to a lender that you are a riskier borrower
- Managing your debt-to-income ratio should be a part of your regular financial hygiene.
If you are contemplating applying for a new personal loan, credit card, or mortgage, understanding your debt-to-income ratio will give you insight into how lenders think about your application. Lenders use the debt-to-income ratio to assess your ability to repay or service a loan. Managing your debt-to-income is something you should do to ensure you get the lowest borrowing costs possible.
What is the Debt-To-Income Ratio?
Your debt-to-income ratio is the amount of your pre-tax income that services paying monthly debt payments. Debt-to-income is expressed as a percentage and easily allows lenders to determine the degree of your borrowing risk compared to other borrowers. Debt-to-income gives lenders the criteria to assess the likelihood that you will make on-time debt payments and eventually pay off your loan.
A low debt-to-income ratio means that you have, on a percentage basis, much less of your monthly income servicing other debts. Lenders like this because their loan has a higher likelihood of being paid off because fewer dollars are competing for debt repayment. For example, if your debt-to-income ratio is 10%, that means that 10% of your pre-tax income is going toward paying your debts each month.
Banks, credit unions, and mortgage lenders love borrowers with a lower debt-to-income ratio because borrowers can easily make debt payments. The last thing a lender wants to do is inappropriately characterize your lending risk profile. Lenders want to properly assess your credit history in context with your debt-to-income ratio to lend to you at the appropriate interest rate.
Smart Money-> See How Debt-to-Income Affects Your Mortgage
On the other hand, if you have a high debt-to-income ratio, this could be a signal that you are over-leveraged or are carrying too much debt relative to your earnings. As a result, lenders tend to look more negatively on high debt-to-income ratios and deem you a higher-risk borrower. Practically, this translates into higher interest rates and an increased cost of debt.
How to Calculate Your DTI Ratio
To calculate your debt-to-income ratio, collect all your monthly sources of income and debt payments.
Include All Debts:
- Credit card minimum payments
- Student loan payments
- Auto loan payments
- Mortgage payments
- Personal loan payments
- Rent Payments
Include All Sources of Income:
- Regular monthly paycheck
- Side hustle income
- Interest income
- Dividend income
- Rental income
- Other passive income
Smart Money-> Need Cash Fast? 12 Ideas for Making Money in an Hour or Less
Here is an example: Let's say you make $10,000 per month (or $70,000 per year) as a marketing manager and own an online business paying you $1,000 monthly. You also have your slush fund savings in a high-interest savings account which generates $150 per month, and you are investing in dividend-paying stocks which pay $350 per month. Overall, you are making $11,500 per month. However, you have a mortgage of $3,000, credit card minimums of $200 per month, and need to pay $300 monthly on a pesky student loan. Overall, you are servicing $3,500 in debt. Your debt-to-income ratio is approximately 30%.
What is A Good Debt-To-Income Ratio?
The debt-to-income ratio gives lenders a quick and easy way to assess whether you have too much debt. From a lender’s perspective, if you have too much debt relative to your income, you are a riskier borrower than someone with less debt and the same income.
Recommendations on what constitutes a fantastic debt-to-income ratio vary from lender to lender and from person to person. The Consumer Financial Protection Bureau offers general guidelines on what constitutes a good debt-to-income depending on your unique situation. To better understand how you should assess your own debt-to-income ratio, here is a Smart Money analysis of what constitutes a great to poor debt-to-income.
Level 1: Debt-to-Income Lower than 20%: If your debt-to-income ratio is less than 20%, you are in the minority of borrowers. You are keeping your debts very low relative to your monthly earnings, which allows you to save for an emergency fund, slush fund, or a down payment on a house. This level has the best financial flexibility. Lenders generally view Level 1 as highly favorable.
Level 2: Debt-to-Income Between 20% to 36%: If you have a Level 2 debt-to-income ratio, you likely have sufficient discretionary income to save or spend after you have paid your bills at the end of each month. The Consumer Financial Protection Bureau recommends homeowners keep their debt-to-income ratio at 36% or less. Lenders generally view this as very favorable.
Level 3: Debt-to-Income Between 36% to 43%: For Level 3 debt-to-income ratios, the financial picture begins to change. A debt-to-income ratio of 43% is typically the highest ratio you can have for a qualified mortgage.
Level 4: Debt-to-Income Between 43% to 50%: Debt-to-income ratios in the Level 4 range are teetering on being too high. If you are at this level, you need to focus on taking action to improve your debt-to-income ratio quickly.
Level 5: Debt-to-Income Over 50%: Wells Fargo, one of the largest lenders in the world, recommends that if you have a debt-to-income ratio of over 50%, it is time to act. At this high debt-to-income ratio, lenders may begin to limit your borrowing options1.
The general rule of thumb is that you want to keep your debt-to-income ratio below 30%. If you can keep it even lower, you will be an even more attractive borrower to lenders. At the end of the day, lenders want to ensure you can repay the money you are borrowing.
Smart Money -> 6 Ways to Improve Your Debt-to-Income Ratio
How Does Your Good Debt-To-Income Ratio Affect Your Credit Score?
Your debt-to-income ratio does not implicitly affect your credit score. Instead, the various components of the ratio, such as your total income, are disparately gathered by lenders throughout the loan approval process.
Smart Money -> What is a FICO credit score?
For example, if you are pre-approved for a loan it is because a lender feels comfortable with your known income and payment history. Alternatively, when applying for a new loan, during the formal application phase, you are required to provide proof of income (such as W-2s, bank account statements, etc.). This gives lenders the denominator for the ratio.
Smart Money -> What is a VantageScore?
Lenders assess your credit score and credit report. Because of this, they will see your credit utilization or the amount of your available credit limit you are currently utilizing. You typically want to keep this below 30%, but lower is better.
Smart Summary
When you apply for a new line of credit, lenders need a method to assess your ability to repay debt. Lenders take a holistic view of your credit history, assets, income, debt-to-income ratio, and other factors to assign you a risk profile. Based on that risk profile, they determine how much and at what costs to lend you capital. To improve your debt-to-income ratio, you can either make more money or pay off your debt. Doing this before you need to take out a loan will save you money in the long run. Keeping your financial house tidy is a smart money habit.
Frequently Asked Questions
The debt-to-income ratio compares your total monthly debt commitments to your pre-tax monthly take-home pay. This ratio provides lenders with a rough assessment of whether you have too much debt. A high debt-to-income ratio indicates you are a riskier borrower, and a low debt-to-income ratio shows you probably have sufficient monthly income to cover your debt payments.
Debt-to-income is calculated by adding up all your outstanding debt payments in a month – credit card minimums, car payments, student loans, personal loans, and other consumer debt – and dividing that by your total monthly gross income. Make sure to include income from any side hustle, interest income, or passive income.
A low debt-to-income ratio is better than a high debt-to-income ratio in the eyes of a lender. A debt-to-income ratio of 30% or lower is a good debt-to-income ratio. To improve your debt-to-income ratio you can either make more money or pay off your debts.
