Your debt-to-income ratio (DTI) compares how much you owe each month to how much you earn. Specifically, it’s the percentage of your gross monthly income (before taxes) that goes towards payments for rent, mortgage, credit cards, or other debt.
The percentage of before-tax earnings that are spent to pay off loans for obligations such as auto loans, student loans and credit card balances. Lenders look at two ratios. The front-end ratio is the percentage of monthly before-tax earnings that are spent on house payments (including principal, interest, taxes and insurance). In the back-end ratio, the other debts of the borrower are factored in.
What is an acceptable debt ratio?
This compares annual payments to service all consumer debts- excluding mortgage payments—divided by your net income. This should be 20% or less of net income. A ratio of 15% or lower is healthy, and 20% or higher is considered a warning sign.
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Is a 50% debt-to-income ratio good?
DTI is less than 36%: Your debt is likely manageable, relative to your income. You shouldn’t have trouble accessing new lines of credit. DTI is 36% to 42%: This level of debt could cause lenders concern, and you may have trouble borrowing money. 36% DTI or lower: Excellent. 43% DTI: Good. 45% DTI: Acceptable (depending on mortgage type and lender) 50% DTI: Absolute maximum.
How to lower your debt-to-income ratio
- If your debt-to-income ratio is close to or higher than 36 percent, you may want to take steps to reduce it. To do so, you could:
- Increase the amount you pay monthly toward your debt. Extra payments can help lower your overall debt more quickly.
- Avoid taking on more debt. Consider reducing the amount you charge on your credit cards, and try to postpone applying for additional loans.
- Postpone large purchases so you are using less credit. More time to save means you can make a larger down payment. You’ll have to fund less of the purchase with credit, which can help keep your debt-to-income ratio low.
- Recalculate your debt-to-income ratio monthly to see if you’re making progress. Watching your DTI fall can help you stay motivated to keep your debt manageable.
- Keeping your debt-to-income ratio low will help ensure that you can afford your debt repayments and give you the peace of mind that comes from handling your finances responsibly. It can also help you be more likely to qualify for credit for the things you really want in the future.
Does debt to income affect credit score?
Your income is not included in your credit report, so your DTI never affects your credit report or credit score. However, many lenders calculate your DTI when deciding to offer you credit. That’s because DTI is considered an indicator of whether you’ll be able to repay a loan.
What factors make up a DTI ratio?
There are two components mortgage lenders use for a DTI ratio: a front-end ratio and back-end ratio. Here’s a closer look at each and how they are calculated:
Front-end ratio: also called the housing ratio, shows what percentage of your monthly gross income would go toward your housing expenses, including your monthly mortgage payment, property taxes, homeowners insurance and homeowners association dues.
Back-end ratio: shows what portion of your income is needed to cover all of your monthly debt obligations, plus your mortgage payments and housing expenses. This includes credit card bills, car loans, child support, student loans and any other revolving debt that shows on your credit report.
How to calculate your debt-to-income ratio:
Debt-to-income ratio (DTI) divides the total of all monthly debt payments by gross monthly income, giving you a percentage. Here’s what you should know:
- Lenders use DTI- along with credit history- to evaluate whether a borrower can repay a loan.
- Each lender sets its own DTI requirement.
- Personal loan providers generally allow higher DTIs than mortgage lenders.
- How to understand your DTI ratio
- Your DTI can help you determine how to handle your debt and whether you have too much debt.
Here’s a general rule-of-thumb breakdown:
- DTI is less than 36%: Your debt is likely manageable, relative to your income. You shouldn’t have trouble accessing new lines of credit.
- DTI is 36% to 42%: This level of debt could cause lenders concern, and you may have trouble borrowing money. Consider paying down what you owe. You can probably take a do-it-yourself approach; two common methods are debt avalanche and debt snowball.
- DTI is 43% to 50%: Paying off this level of debt may be difficult, and some creditors may decline any applications for more credit. If you have primarily credit card debt, consider a credit card consolidation loan. You may also want to look into a debt management plan from a nonprofit credit counseling agency. Such agencies typically offer free consultations and will help you understand all of your debt relief options.
- DTI is over 50%: Paying down this level of debt will be difficult, and your borrowing options will be limited. Weigh different debt relief options, including bankruptcy, which may be the fastest and least damaging option.
How Does the Debt-to-Income Ratio Differ from the Debt-to-Limit Ratio?
Sometimes the debt-to-income ratio is lumped in together with the debt-to-limit ratio. However, the two metrics have distinct differences. The debt-to-limit ratio, which is also called the credit utilization ratio, is the percentage of a borrower’s total available credit that is currently being utilized.
In other words, lenders want to determine if you’re maxing out your credit cards. The DTI ratio calculates your monthly debt payments as compared to your income, whereby credit utilization measures your debt balances as compared to the amount of existing credit you’ve been approved for by credit card companies.