There are many factors that go into financial fitness. From having an emergency fund to increasing your credit score and so much more, it can seem like it’s a lot to keep track of. And at first, it can be overwhelming. But once you get into the habit of managing all aspects of your finances, it gets easier and easier to do.
One aspect of financial fitness that doesn’t get a lot of attention is debt-to-income ratio. Lenders will look at this number and use it to determine how much of a lending risk you are. It’s important to understand that number and learn how to calculate it, so you’re always aware of where you stand and can be prepared to make changes.
We’re going to show you how to make this calculation. And don’t let the idea of math scare you off. This formula is simple, and we’ll break it down for you step by step.
How to Calculate Your Debt-to-Income Ratio (DTI)
Before you get started, you’re going to need two important numbers. The first is how much your monthly debt payments are. To get this number, consider all the debt you currently pay. Focus on debt where payments are made against borrowed money. This includes things like mortgage payments or rent payments if you don’t currently own a home, credit card minimums, and auto loan payments.
Add up all those monthly payments and write down the total. Then take a look at your gross monthly income, and don’t forget any additional income like alimony or child support. Once you’ve added up your total monthly income, simply divide your debt by your income. If you want to be extra cautious, you can make a similar calculation using your net pay, or take-home pay, rather than using your gross monthly income. This will ensure a little more stability since lenders always use gross pay when calculating DTI.
Here’s an example:
- Mortgage: $1300
- Car Payment: $325
- Student Loan: $150
- Credit Cards: $350
- Total: $2125
- Salary: $6500
- Child Support: $550
- Additional Income: $250
- Total Income: $7300
What is a Good Debt-To-Income Ratio?
Now that you know how to calculate this number, you’re probably wondering how to know if the number you got is good or not. Unlike a credit score, there’s no standard for what is considered a good debt-to-income ratio (DTI), but the higher the percentage, the more risk you represent to the lender. In general, it’s a good idea to keep your DTI below 36%:
- 36% or Lower – This is the standard threshold that most lenders consider to be an average to low-risk DTI. It’s a good number to aim for, and of course, the lower, the better.
- 36% - 42% - Lenders start to get concerned about risk at this level of DTI. If you fall into this category, you’re probably more focused on managing debt than saving money. You’ll likely still qualify for loans and lines of credit but be sure to keep an eye on your DTI.
- 43% - 50% - Most lenders will not approve applications for anyone with a DTI at this level because it indicates that you already owe nearly half your income to debt payments. Getting a loan or line of credit at this point would likely cause an unmanageable amount of debt.
- Over 50% - This is a severe level of debt and you’ll be unlikely to get approved for any loans or lines of credit. At this DTI, it’s important to focus on managing your debt and considering more intense debt relief options such as bankruptcy.
How to Improve Your Debt-to-Income Ratio
If you’re planning on applying for a mortgage soon or you want to make a large purchase, like a car, you’ll want to make sure your DTI is in good standing. Lenders will look at this number and judge your risk by it, so you should consider it an important number to indicate your financial fitness as well.
Increasing your income by getting a raise, taking on a second job, or even starting a side hustle are all good ways to improve your DTI and get you some extra cash to pay off/down your debt faster.
Larger DTIs may require more intensive solutions such as debt consolidation. If your DTI is above 43%, consider working with a debt professional to help you manage what you owe. The best strategy is to pay down debts that will help you improve your credit score so that you can then apply for a consolidation loan.
For DTIs between 36%-42%, you have a few options. First, make sure you understand the terms of all your monthly debt payments. Consider if it’s time to refinance or transfer the balance of one of your cards. Look at your monthly budget and see if there are some expenses you can spare in exchange for paying off your highest interest debt.
Little steps can go a long way in improving your DTI. But remember, your financial fitness is in your hands. The more attention you pay to your debt, income, and monthly budget, the better prepared you’ll be when it’s time to make a big purchase.