Meeting your life goals can often involve taking on debt, whether that is seeking student loans to finance your education or taking out a mortgage to buy a home. However, it’s important that your debt load remains manageable; to be able to keep your payments steady and stay financially healthy.
The debt-to-income ratio is one metric you — and lenders — can use to assess your financial health. A “good” ratio signals that you carry a manageable amount of debt, while a “bad” or too-high ratio indicates that you may have taken on more debt than you can handle. Maintaining a good ratio may make you a more attractive candidate to lenders, so you’re more likely to be approved for loans or to secure better interest rates.
Understanding and managing your debt-to-income ratio is especially important if you’re seeking a large loan, such as a mortgage. Read on to learn what it means to have a “good” debt-to-income ratio and how to calculate your debt-to-income ratio.
First, what is debt-to-income ratio and how does it work?
A debt-to-income ratio (sometimes referred to as DTI) illustrates how your debt level compares with your income. It’s expressed as a percentage — the lower the percentage, the less of your monthly income goes toward paying down your debt.
A low DTI often means that you carry a manageable amount of debt and indicates to lenders that you can pay off your debts comfortably. Conversely, a high DTI may signal that you’re overburdened with debt and may face difficulty making your payments regularly.
The debt-to-income ratio is one of several factors lenders may use to consider your financial situation when you apply for credit, such as a loan or mortgage. Along with other metrics, such as your credit report or credit score, lenders can gain insight into your financial situation and make a decision about whether to lend you money. Lenders also use DTI to estimate how large of a mortgage you can reasonably afford, which may influence how much you’re approved for.
What is a good debt-to-income ratio?
While different lenders may have different standards for what’s considered a “good” debt-to-income ratio, there are a few guidelines to be aware of. Generally, lenders prefer that applicants maintain a debt-to-income ratio lower than 36%, meaning that less than 36% of their monthly income goes toward debt repayment. Aim for 20 to 35% to maintain a good DTI ratio.
Your DTI must be 43% or less to secure a Qualified Mortgage, a class of loan designed to protect both the lender and borrower from risky mortgage lending practices. When you apply for a mortgage, lenders will use DTI to help determine how large of a mortgage you’ll qualify for. This protects you from taking out a larger mortgage than you can afford.
Wondering where your DTI falls now? It's not hard to calculate.
How do you calculate debt-to-income ratio?
Calculating your debt-to-income ratio is simple, as long as you’re aware of both of the following:
- Your gross monthly income: The amount of money you make each month, before income tax or other deductions.
- Your monthly debt repayments: The payments you make toward debt repayment, including auto loan payments, credit card payments and monthly mortgage payments.
Knowing these variables, you can calculate your DTI according to the formula below:
|Debt-to-Income Ratio Formula:|
|Monthly debt payments / Gross monthly income = Debt-to-income ratio|
For example, an individual with a gross monthly income of $7,500 and monthly debt payments of $2,500 — a $1,800 mortgage payment, $400 car loan payment and $300 credit card payment — has a DTI of 33%.
Have you calculated your debt-to-income and found that it's higher than is recommended? There are some things you can do to improve your debt-to-income ratio.
How can you improve your debt-to-income ratio?
Those looking to reduce their debt-to-income ratio have three general ways to do so: by increasing monthly income, reducing debt or some combination of the two. The following tips can help you achieve a lower ratio:
- Pay off debts more aggressively. Consider paying off more than the minimum amount due on credit cards or other debts.
- Avoid taking on more debt. Limit credit card transactions to the essentials and postpone non-essential plans, like weddings or renovations, that might cause you to take on debt.
- Seek out additional income streams. Look for advancement opportunities at work or generate income from a second job or side business.
- Increase your passive income. Consult a wealth advisor for ways to maximize your returns on investments.
Achieving a low debt-to-income ratio is key for those looking to become homeowners since excessive debt can impact your homebuying power. By managing your debt levels or increasing your income, you can achieve a DTI that helps make you an attractive borrower.
If you’re getting ready to take out a mortgage or loan, First Republic can help. Contact our Client Care Center to connect with an expert who can help you manage your DTI and explore your lending options.