How Your Debt-to-Income Ratio Affects Your Eligibility for New Credit
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Your debt-to-income ratio is a measure of your monthly income compared to your monthly debt obligations — that includes most of the bills you pay. Debt-to-income ratio is an important factor in applications for new credit, especially mortgages.
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When you apply to borrow money, lenders look at a number of factors as they decide whether to approve or deny your request. One factor, called your debt-to-income ratio, gives a lender clues about whether you can afford to take on the new debt and repay it as promised.
Whether you’re seeking a mortgage, an auto loan, a home equity loan, a personal loan, or a credit card, your debt-to-income ratio will affect your chances of qualifying. Read on to discover how lenders calculate your DTI ratio, why it matters, and what you can do if your DTI ratio is too high.
What Is Debt-to-Income Ratio?
Before any financial institution lends you money or extends you credit, it will want to make sure that you’re financially capable of paying back what you borrow (plus interest). One way to determine whether you have the financial footing to handle a new loan or credit limit is to compare the money you earn to your monthly financial obligations.
This comparison of monthly income versus debt is known as your debt-to-income ratio, or DTI for short.
Put another way, your DTI ratio is the percentage of your income (gross, monthly) that you’re using to cover your monthly debt payments. It’s a measurement of your borrowing capacity. A lower DTI ratio is better, in terms of the lender’s risk, since you have more money available to repay the money you borrow.
It’s worth noting that your debt-to-income ratio does not impact your credit scores. Since your credit reports do not contain any details about your income, you won’t find any DTI references in your credit history.
Front-End and Back-End DTI Ratios
There are two types of debt-to-income ratios: Front-end DTI and back-end DTI.
Mortgage lenders are interested in the front-end ratio. Some refer to this measurement as the housing ratio because the calculation incorporates your:
- Monthly gross income
- Total mortgage payment (principal, interest, taxes, homeowners insurance, mortgage, and — if applicable — HOA fees)
A mortgage lender divides your mortgage payment (or expected monthly payment) by your gross monthly income to calculate your front-end DTI ratio.
As for your back-end ratio, lenders look at all of your monthly debt payments that appear in your credit reports. These include your minimum credit card payments, student loans, auto loans, and other types of credit. Back-end DTI may also include other monthly expenses like child support and alimony.
Typically, when someone refers to a debt-to-income ratio, they’re thinking of the back-end version. Back-end DTI gives a fuller picture of a borrower’s monthly debts and gives insights into the person’s ability to repay.
Why Understanding Your DTI Ratio Is Important
Understanding your debt-to-income ratio can help you make informed financial decisions. It can help you decide whether to apply right now for a loan or credit card, or whether it might be beneficial to wait.
If your DTI is high, your budget may not be able to handle an extra payment at this time.
“Evidence from studies of mortgage loans [suggests] that borrowers with a higher debt-to-income ratio are more likely to run into trouble making monthly payments,” according to the Consumer Financial Protection Bureau.
Since DTI is absent from your credit reports, a high DTI ratio will not have a direct negative impact on your credit scores. But it can lead to other adverse outcomes such as:
- Being rejected for a new loan or credit card
- Not being able to borrow as much money as you need
- Paying higher annual percentage rates (APR)
Sometimes, your debt-to-income ratio can affect other financial agreements as well. For example, landlords often use DTI ratios to determine if tenants can handle their rent payments each month. It’s a lengthy and expensive proposition to evict a renter, which is why they often rely on these ratios.
How to Calculate Your Debt-to-Income Ratio
To calculate your debt-to-income ratio, start by adding up how much you pay each month to satisfy your debt obligations. This figure may include any of the following:
- Mortgage payment (or expected mortgage payment)
- Car payment
- Minimum payment on each credit card
- Personal loan payments
- Student loan payments
- Any other type of debt payments
You will also need to know your monthly housing costs such as property insurance, property taxes, HOA fees, etc. However, you can leave out most expenses that aren’t featured on your credit reports including utilities, auto insurance, health insurance, childcare, retirement savings, etc.
Once you have your list of total monthly debt payments, it’s time to move on to income. Here, you’ll need to determine your gross monthly income before taxes are taken out.
Calculating Your Front-End DTI Ratio
Now that you have all the financial figures you need, you’re ready to calculate your DTI ratio. For your front-end ratio, add your mortgage payment (or what you pay for rent), plus what you spend per month for any housing costs like homeowners insurance and property taxes.
Divide total housing costs by your monthly gross income to come up with your front-end DTI ratio.
Note: The initial number you calculate will feature a decimal point. (For example, $2,000 monthly housing costs / $6,000 gross monthly income = 0.33.) You’ll need to take the initial number and multiply it by 100 to get your final answer. (0.33 X 100 = 33%)
Calculating Your Back-End DTI Ratio
For your back-end DTI ratio, you can begin by adding up all of your debt obligations, including those monthly expenses from your front-end DTI calculation.
Divide your total monthly expenses by your gross monthly income to determine your back-end DTI ratio.
Don’t forget to multiply the decimal by 100. When you’re done, you’ll have the main DTI ratio lenders review when trying to determine your capacity to manage new debt.
The Consumer Financial Protection Bureau has a DTI Ratio Calculator to help you once you have collected all of your financial data.
What Is a Good DTI Ratio?
After you calculate your debt-to-income ratio, you will arrive at a figure. But what does this number mean? From a creditor’s perspective, the higher your DTI percentage, the greater the risk.
Each lender will determine its criteria for DTI ratios. There’s no universal cutoff point between a good DTI ratio and a bad one. However, here are some general guidelines courtesy of the CFPB:
- 43%: In general, this is the highest ratio you can have and still be eligible for a qualified mortgage. (There are some exceptions.)
- 36%: The CFPB recommends homeowners maintain a DTI ratio of 36% or less.
- 28%: Mortgage debt should ideally be 28% or less.
- 15%–20%: Renters should aim for a DTI ratio between 15%–20% for their debts. Your monthly rent payment does not figure into this calculation.
What Is a Good DTI Ratio for a Credit Card Application?
Credit card issuers consider DTI ratios as well, though not to the same extent as mortgage lenders. Again, each card issuer will set its own threshold when it comes to the maximum DTI it’s willing to tolerate. But if your DTI is 35% or under, you may have better approval odds when you apply for a new credit card.
How Can You Improve a Debt-to-Income Ratio That’s Too High?
A lower debt-to-income ratio suggests you will be more successful at repaying a new debt with the amount of monthly income you have available. So, if your DTI is on the high side, your goal should be to reduce that number.
Here are three steps you can take if you discover your DTI ratio is too high:
- Increase the amount of income you make each month.
- Decrease your monthly debt payments each month.
- Aim for a combination of both of the above.
Looking for effective ways to pay down debt? Check out these 6 debt elimination strategies that work.
Knowledge Is Power
It’s good to understand your debt-to-income ratio. Knowing this important number can inform your decisions about whether it’s a good time for you to take on additional debt.
Calculating your DTI ratio can also reveal whether your current lifestyle is sustainable on your current monthly income. And if you’re trying to pay down your debt, DTI can be a good measurement to help you track your progress.
Michelle Lambright Black is a leading credit expert, author, writer, and speaker with over a decade and a half of experience in the credit industry. She is an expert in credit reporting, credit scoring, financing (mortgages, credit cards, loans), debt eradication, budgeting, saving, and identity theft. She is featured monthly at credit seminars, podcasts, and in print. You can connect with Michelle on Twitter (@MichelleLBlack) and Instagram (@CreditWriter).
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