While most are familiar with the concept of loans (and taking out a loan), many know less about how loan decisions are made and what makes a creditworthy applicant. One metric lenders use to determine your ability to repay loans is called your debt-to-income (DTI) ratio, a financial measure that compares an individual’s monthly debt payments to their gross monthly income. To improve your chances of getting a loan approved, it’s important to understand how DTI is calculated, why it’s important, and how to improve it.
How to calculate debt-to-income ratio
First, a little math. Begin by adding up all of your recurring monthly expenses. These will likely include things like rent or mortgage payments, utilities, loans, and credit card payments. Divide that sum by your gross monthly income, which is the amount you earn each month before taxes and other deductions.
So, let’s say your monthly expenses total $2,000, and your gross monthly income is $8,000.
$2,000 ÷ $8,000 = 0.25. This means you spend 25 percent of your income each month on expenses. In general, the lower your DTI ratio, the better, because it demonstrates a balance between income and expenses and an increased ability to pay back loans. A DTI of 20% or less is considered low, while the Federal Reserve considers a DTI of 40% or more a sign of financial stress.1
Why your debt-to-income ratio is important
Your debt level can adversely affect your credit score, making it more difficult to obtain personal loans and even gain approval for mortgages. Diligently monitoring your credit report, which includes information lenders use to determine creditworthiness, can help keep you out of debt. Staying out of debt, in turn, helps keep your DTI low. All of these factors come into play when determining if you will be able to take out a loan when you need one.
How to improve your debt-to-income ratio
If your debt-to-income ratio is higher than it should be, there are actionable steps you can take to improve it.
Reduce your monthly expenses - This may mean cutting back on non-essentials and entertainment costs in the short term to set you up for long-term financial wellness. Creating and maintaining a proper budget can help illuminate areas where you can cut out costs — for example, if you’re eating out for every meal, consider dining at home more often. Resist the urge to jump at every sale you get an email about and avoid taking on more debt by opting for cash whenever possible over a credit card. Utilizing a budget calculator is a great way to add transparency and accountability to your budgeting process.
Increase your gross monthly income - Often easier said than done (and really, a permanent goal for most), earning more money each month will have a direct positive effect on your DTI ratio. Consider freelance or part-time work, asking for a raise at your current job, or selling items you may no longer wear, use or need.
Consolidate your debt - When you consolidate debt, you get to combine several different pre-existing debts with various due dates and interest rates into one payment. If the interest rate on your debt consolidation loan is lower than the old debt, you can save money and lower your DTI.
Tackle your credit cards - If you’re paying off one card at a time, start with the highest interest rate card and go from there. See if you can even manage to make double your monthly minimum payment. Consider combining cards — you’ll often end up paying a lower balance per month with only one interest rate to contend with, leaving you money to pay off balances more aggressively. Finally, as you’re working concurrently to reduce expenses, put off larger purchases until you have some extra funds to work with.
Stick with it
As with any financial endeavor, improving your debt-to-income ratio takes time and commitment. But making an effort to decrease your debt-to-income ratio will benefit you — literally and figuratively — as you work toward home ownership, financing your education, or paying off debt. Remember to regularly check your DTI ratio to track the progress you’ve made!
1 https://www.nerdwallet.com/blog/loans/calculate-debt-income-ratio/
