If you’ve ever applied for an auto, home, or personal loan, you may have heard your financial institution mention your debt-to-income ratio. Your debt-to-income (DTI) ratio is the amount of all your monthly debt divided by your gross monthly income. This ratio is used by lenders to determine your ability to manage all of your monthly payments to repay the money you borrow.
Simply add up all of your monthly debt payments. This would include credit cards, auto and mortgage loans, personal loans, and student loans. Divide this number by your gross monthly income and you will accurately calculate your DTI.
So, what is considered a high DTI? Generally speaking, 43% is the maximum DTI a lender will approve for a qualified mortgage loan. A reasonable DTI is considered under 36%, while most consumers feel more financially comfortable around 30%.
Here is an example:
Total monthly debt obligations: $2,070
Total gross monthly income: $5,000
Debt-to-income ratio = 2,070 / 5,000 = 41.14 %
There are many reasons why we should have some debt and a reasonable amount is healthy, providing you with more buying power in the marketplace. However, a high DTI can affect you in more ways than one.
1. You may not get the loans you need
If you have a high DTI, you may be declined for financing even if you have a great credit score. Even with a credit score over 730, you could be declined for a small loan due to your DTI. Creditors want to ensure you are not sinking in monthly payments before they extend credit to you.
2. You may be financially stretched if it’s too high
With a high DTI, you may find yourself living paycheck-to-paycheck. Consider this, if you were to lose part or your full income source, the harder it would be to repay your creditors if you have a high DTI.
3. If you lost your income, you could ruin your credit
Losing your income with high monthly bills, could mean that your credit is negatively affected. The lower your monthly bills, the easier it is for you to survive if the unthinkable were to happen. For this reason, it is very important to have an established emergency fund. Emergency funds are the best way to ensure you have the funds you need when life gets a bit out of control. Be it a medical emergency, or a layoff, be prepared for life by saving each month.
Looking to lower your DTI?
Lower your DTI by decreasing the amount of credit you use and by paying off your debt as you are able. Student, auto, and mortgage loans are harder to payoff, so refinancing is the best option if these monthly payments seem too high. Focusing on paying off credit cards and personal loans is usually easier and more appropriate as these loans also tend to have higher interest rates.
Have any questions about your debt-to-income ratio? Let us know!