What is a debt-to-income ratio?

The debt-to-income ratio calculates the percentage of your gross monthly income used toward all your monthly debt payments. Your gross monthly income is the amount of money you earn before taxes and other deductions. In more basic terms, the DTI ratio is a metric to assess your creditworthiness and ability to make your debt payments. The debt-to-income ratio will be analyzed by lenders when you apply for personal loans. The DTI ratio provides lenders with a sense of whether you can repay your current debt and assume a new loan.

For U.S. consumers, the current economy may be considered the best of times and the worst of times. On the positive side of the ledger, median weekly earnings for the nation’s 121 million full-time age and salary workers rose 5.5% to $1,145 in the fourth quarter of 2023, compared to a year earlier, according to data from the Bureau of Labor Statistics. The pay increase edged out the 3.2% increase in the Consumer Price Index for All Urban Consumers (CP-U) in the same period.

On the ledger’s negative side, however, total household debt rose by $212 billion to reach $17.5 trillion in the fourth quarter of 2023, according to the latest Quarterly Report on Household Debt and Credit by the Federal Reserve Bank of New York.

Examining the debt by individual sources during the quarter, credit card balances increased by $50 billion to $1.13 trillion, while mortgage balances rose by $112 billion to $12.25 trillion. Auto loan balances climbed $12 billion to $1.61 trillion, continuing an upward trajectory that began in 2011. Delinquency transition rates increased for all debt types except for student loans, according to the Federal Reserve Bank of New York.

How do I calculate my debit-income ratio?

You must first add up your total monthly debt, including mortgage, car loans, credit card bills, student loans, and any other loan payments. You can also include court-order fixed payments, such as alimony or child support. Next, calculate your monthly gross income, i.e., the amount before taxes and deductions. Finally, divide your total monthly debt payments by your monthly gross income. For example, if you have a $2,000 mortgage payment and a $350 car loan payment per month and earn $5,000 a month, the DTI is 47%: $2,350/$5,000 X 100). The website Consolidated Debt offers a free DTI calculator.

Here is how to calculate the debt-to-income ratio:

* Total Debt Payments: $2,350

* Gross Monthly Income: $5,00

* DTI ratio: 47% ($2,350/$5,000 X 100)

When you apply for a mortgage, a lender will scrutinize your finances, i.e., your credit history, monthly gross income, and the funds you have set aside for the down payment. To determine the maximum loan, lenders will examine your debt-to-income ratio. Many lenders prefer a DTI ratio of 45% or lower. A higher debt-to-income ratio may not mean that your application is rejected if you are managing your monthly cash flow carefully and paying your debt payments in a timely manner. However, a DTI ratio that is too high may indicate a large debt load and that you may struggle to take on additional debt. Each lender has its own preferences for measuring the DTI ratio when deciding if you qualify for the line of credit or other loan.

You can lower the DTI by paying down your debt or obtaining a side hustle in your spare time to boost your monthly income.

Two parts of debt-to-income ratios

Front-end ratio: The front-end ratio or housing ratio refers to the portion of your income earmarked for housing-related expenses. The expenses may include rent or mortgage payments, homeowner’s or renter’s insurance, and property taxes.

Back-end ratio: This includes the percentage of your gross income used to pay all your monthly debt bills, including housing. The ratio can comprise car loans, credit card bills, and student loans. Lenders generally favor a back-end ratio of 36% or lower.

What is the best debt-to-income ratio for a mortgage

Mortgage lenders tend to closely scrutinize your DTI ratio when you apply for a new mortgage, a refinance of an existing loan, or a home equity line of credit. Mortgage lenders tend to examine front-end and back-end debt-to-income ratios, and may reject your loan or refinance application if you are burdened with excessive debt compared to your income.

The Consumer Financial Protection Bureau recommends that homeowners consider maintaining a debt-to-income ratio for all debts of 36% or less, although some lenders may go up to 43% or higher. However, when reviewing your mortgage application, lenders usually don't examine household expenses such as cable TV and cell phone bills or college tuition that may start a few years after you begin paying your mortgage. It's best to keep these expenses in mind to avoid burdening yourself with excessive debt.

Guidelines for mortgage applications are usually more stringent for conventional loans compared to mortgages backed by government agencies, such as the Federal Housing Administration (FHA) or the U.S. Department of Veterans Affairs (VA). DTI ratios can vary between 41% and 50%, contingent on the type of loan you are seeking.

Impact of a high debt-to-income ratio

The DTI ratio is not part of your credit report, but a high percentage can negatively impact you. For example, a high DTI ratio may cause lenders to be wary about giving you a loan. Lenders may not greenlight your applications for new loans or revolving loans.

With a high DTI ratio, lenders may rate you as a more uncertain borrower. Therefore, they may charge you higher fees and interest rates. You may be charged higher closing costs or interest rates when purchasing a house. If your debt-to-income (DTI) ratio exceeds 45%, you might incur higher private mortgage insurance (PMI) costs, further elevating your DTI ratio.

Ways to Lower your DTI ratio to obtain a mortgage

If your DTI ratio must decrease to obtain a mortgage, there are a few steps you can take to lower it. These recommendations can help you obtain a favorable mortgage rate and monthly payment.

• Increase your down payment. This can help reduce your monthly payments. Methods to accomplish this goal can include: waiting a few months or more to boost your savings, or borrowing from your 401(k) plan or a relative.
• Boost your credit score. To achieve this goal, it’s prudent to lower your credit card debt (balances that are carried over each month) and don’t apply for new credit cards. It may be necessary to lower your monthly expenses to free up money to reduce your credit card balances.
• Seek less expensive homeowners insurance: Lowering the homeowner's insurance reduces your mortgage payments and, in turn, your DTI ratio.
• Obtain a cosigner: Most mortgage lenders permit you to borrow with another person, even if they will not reside in your home. The co-signer must be advised that they will be responsible for mortgage payments if you fail to pay them.

Impact of debt-to-income ratio on your credit score

Your debt-to-income ratio is not a component of your credit report and will not lower your credit score. Credit agencies don't know your salary or other sources of income. As a result, they can't determine your DTI ratio. Nevertheless, a high DTI ratio may be a harbinger of a high credit utilization ratio, which affects your credit score.

Your credit utilization ratio calculates your total debt divided by how much credit you have access to or your credit limit. This means that if your credit card has a balance of $1,000 and a $2,000 credit limit, your credit utilization ratio is 50%. The credit utilization ratio does have a significant role in how your credit score is tabulated. For example, in the FICO Score model (the score range is 300 to 850), credit utilization includes about 30% of the final credit score. As far as the VantageScore, credit utilization represents 20% of your overall credit score.