Surprisingly, the actual accumulation of debt is not what overwhelms some people. Instead, it’s the way debt grows in relation to salaries that inevitably adds stress. The ability to successfully control spending habits comes naturally to some people. But the majority of consumers need to diligently work at achieving the desired equilibrium between paying off debts and earning a decent income.
This leads us to the question: what is a good debt-to-income ratio, and why do I need to pay careful attention to it? Consider the following queries:
- What is the definition of DTI?
- How do you calculate your ratio?
- What is a good income to debt percentage?
- How do you reduce your ratio?
- Does DTI ratio impact credit scores?
- What is included in the debt to income ratio?
Definition of DTI
A debt-to-Income ratio (DTI) is computed by dividing your total monthly recurring debt obligation by your gross monthly income. This calculation plays a role in determining the feasibility of being approved to rent/buy an apartment, purchase a car, take out a personal/business loan, or start a new job.
Credit service providers tend to look at a potential borrower’s DTI ratio when deciding whether to approve a line of credit. A DTI ratio is used to determine whether the individual (or business) has the means to take on and, consequently, repay any additional monthly agreements. If the DTI ratio is too high, lenders may reject a borrower’s credit application.
In addition to the DTI ratio, financial institutions may also examine the borrower’s monthly debt-to-limit ratio. Also known as the credit utilization ratio, the debt-to-limit ratio indicates how close a person is to reaching the upper limits of their credit borrowing restrictions. Although the debt-to-limit ratio can be included, it does not impact the DTI ratios but simply gives an indication of the solvency of the candidate.
How to Calculate the Debt-to-Income Ratio?
A DTI ratio is calculated by applying your gross monthly revenue—before deducting taxes and other costs—to the usual monthly recurring debt. This calculation will yield a value as a percentage that represents your debt-to-income ratio.
When your gross monthly income amounts to $6,000, for example, and your expenses include $1,500 for rent, $100 vehicle loan, $150 credit card debt, and $250 of other debt or loan payments—i.e., $1,500 +100 + 150 + 250 = $2,000—then your DTI ratio would total 33.3%.
What is a Good Percentage of Debt-to-Income Ratio?
Consider again the question: What is a good debt-to-income ratio? In 2019, the average American household showed a DTI ratio of 9.69% This figure dropped to a remarkably low 8.69% in 2020.
Moneylenders generally approve anything below 36% to be the ideal debt-to-income ratio. Some state approved loans, however, allow levels of 41 to 43%. But these concessions come at a high price, with steeper interest rates and more rigid terms applicable to debtors with higher DTIs.
Note the distinction between a front-end ratio and a back-end DTI ratio:
A front-end DTI ratio refers to the percentage of your monthly gross income allocated to housing expenses. These include mortgage repayments, property taxes, and home insurance, with no more than 28% of the total DTI ratio appropriated to these particular expenditures. In order to improve DTI ratio scores, borrowers can contact the Federal Housing Administration to insure the loan, so as to secure a better offer from credit facilities.
Conversely, utilizing a back-end ratio is inclusive of all monthly recurring debt and should not exceed 36%. Nonetheless, establishing a healthy savings balance or, alternatively, offering a sizable down payment, can render these terms negotiable.
What is Included in the Debt-to-Income ratio?
When deciding how to figure out debt-to-income ratio, there is a list of certain expenses that needs to be addressed, including:
- Monthly rent/mortgage
- Homeowners insurance
- Real estate taxes
- Monthly homeowners association installments
- Car loans
- Personal loan payments
- Student loans
- Alimony/child support
- Credit cards
Note that all of the above may not collectively exceed 36% of overall income. The cost of utilities, health insurance, transportation, a savings account, food, entertainment, and clothing, are not usually included in debt-to-income ratio calculations.
Does DTI Ratio Impact Credit Scores?
Using scoring models from data analytics companies FICO and VantageScore—which slightly differ from each other—the average credit score in the United States of America is estimated to be 711, on a scale of 200 to 850.
When applying for a credit facility (a type of loan made in a business or corporate finance context), the DTI ratio is used as one of the criteria. Together—with credit reports and credit scores—an applicant’s credibility and suitability as a prospective debtor is determined. This is why it’s important to take measures toward achieving an ideal debt-to-income ratio.
But as the rate of the applicant’s actual income is not available for scrutiny, the DTI ratio cannot be successfully calculated. Hence, the DTI ratio does not impact the outcome of credit scores.
Credit scores are calculated by using the following benchmarks:
When calculating credit scores, credit bureaus carefully comb through past debt commitments, as well as assiduous payments of installments and premiums. Depending on the scoring model used, your payment history accounts for 28-35% of your credit score.
A credit history reflects your credit behavior over a period of time. It assesses your trustworthiness in keeping monthly debt paid, as well as how you manage your accounts. Credit reports comprise 15% of credit scores on the FICO scoring model.
If you’re wondering how to get a good debt-to-income ratio, then you should properly manage the credit you’ve accumulated. Make sure that you commit to payments, avoiding an accumulation of debt.
The credit utilization ratio (debt-to-limit ratio) compares outstanding credit card payments to what is available on approved credit limits.
So, what is a good credit utilization ratio? A credit utilization ratio of 30% is generally accepted by most lenders, as this score is confirmation of the responsible application of credit made available to the specific debtor. This element in credit scoring accounts for about 23%.
Credit distribution refers to the manner in which the credit card holder disperses available credit. Credit bureaus pay particular attention to the type of obligation adopted and the debt payoff reached. This piece of the credit score pie is worth 10% of the whole.
Another part of the puzzle to consider when calculating a credit score is new debt. In judging the ability of a client to pay off debt, the appearance of new financial burdens factors in 15% of your credit score.
Reducing Debt-to-Income Ratio
If your DTI ratio is too high, there are several financial measures you could employ:
Increase Monthly Income
The obvious solution to debt outpacing expected income is to increase your overall income. This could be accomplished by securing a second job or taking on extra shifts or hours at work.
You could also work on improving your skill set to obtain an appropriate debt-to-income ratio. Plan to further develop your proficiencies and then ask for a salary increase to match your value and marketability.
There is also the possibility of finding another employer who would more appreciate your particular set of talents and pay accordingly.
Decrease Runaway Debt
Another tip on how to improve debt-to-income ratio is by decreasing recurring monthly debt. It isn’t an easy task, but it’s an essential step in curbing impulse spending.
Try to avoid taking on more debt or making large, expensive or unnecessary purchases. If possible, increase the amount paid on monthly installments, so as to shrink your DTI ratio and ultimately fix your credit score.
Design a Creative Budget
A budget is an absolute necessity when paying off debts and attempting to reduce debt-to-income ratio. In thinking about a budget, a beneficial mindset would not be about limiting what you can spend but rather giving yourself consent to spend without remorse or feelings of regret.
When drawing up a budget, start by calculating your overall income. Next, you should detail and prioritize debt concerns in order of importance and necessity. Set out goals you wish to achieve and devise a comprehensive, appropriate repayment plan. If necessary, identify the seemingly harmless spending habits that are surreptitiously siphoning hard-earned income and cut these from your inventory.
Remember to regularly revisit your budget, so as to adjust goals according to improved expenditures and practices.
Apply for a Credit Consolidation Loan
If you’re still uncertain as to how to go about reducing debt-to-income ratio, it may become necessary to apply for a loan to consolidate your remaining obligations.
There are many benefits of securing a consolidation loan:
- A consolidation loan merges (consolidates) all various types of debt (e.g., credit card payments, mortgage installments, and other recurring monthly financial responsibilities) into one all-encompassing account. Consequently, debtors become liable for a single monthly loan repayment rather than several separate amounts. This tactic serves to strengthen the individual’s credit score and effectively increase reliability and creditworthiness of credit applicants.
- The upshot of combined debt is lower interest rates. In fact, the Average Percentage Rate (APR) on a consolidation loan can be as little as 14%, in comparison to 16 to 20% on typical personal loans.
- Another benefit of securing a debt consolidation loan is that interest rates and repayment terms are fixed and do not change once you have accepted the terms. Although requirements essentially differ from one financial institution to the next, the best credit card consolidation loans usually consider the DTI ratio together with credit scores. This is considered before deciding on whether to approve or reject a loan application. Shop around to find the consolidation loan option that best suits your needs.
Debt consolidation loans are available from credit unions and local banks, in addition to online lenders—although these backers tend to offer higher APRs. Accordingly, annual percentage rates may differ, depending on the lending body, as shown in the table below:
|Financier||Minimum Credit Score Required||APR Range %|
|LendingClub||600||10.68 – 35.89%|
|Upstart||580||7.98 – 35.99%|
|Avant||580 (FICO)||9.95 – 35.99%|
|OneMain Financial||Not specified||18 – 35.99%|
|Best Egg||700||Over 3 to 5 years 5.99%|
|PayOff||Not specified||Over 2 to 5 years
|Upgrade||Not specified||Over 3 to 5 years
6.94 – 35.97%
Be sure to read the fine print and terms and conditions before committing to a debt consolidation offer.
If you have a poor credit score, then you should take the necessary measures in fixing your credit score before applying for loans.
Debt-to-income ratio is calculated by dividing a client’s total monthly recurring debt by gross monthly income. The resultant number can affect the eligibility to secure loans or obtain mortgages. Borrowers can seek to attain the best debt-to-income ratios by decreasing monthly credit card payments and commit to the consolidation of all active debt by way of a reliable banker.
It’s important to know that a DTI ratio of 36% or less bolsters the chances of a potential loan application being approved. But a front-end ratio—incorporating housing costs—should not exceed 28% of your gross monthly income.
Although a good debt-to-income ratio doesn’t necessarily influence credit scores, it can pave the way to better interest rates and terms of personal loan repayments.
The debt-to-income ratio on credit card repayments should be calculated on a monthly basis, as it is likely to change. A ratio of 0 to 20% is regarded as “very good,” while 21 to 40% is rated as “fair.” But a DTI ratio that spans 41 to 60% may be seen as an indication of an overstretched budget and a potentially risky investment. A ratio that exceeds 60% is indicative, for example, of the account holder’s credit facilities being severely over-extended.
Most lenders will accept a DTI ratio as high as 45 or 50%. But a ratio of less than 36% is preferable and will, undoubtedly, guarantee the buyer better interest rates and repayment conditions. It’s also a good idea to settle as much of your existing debt as possible before applying for a mortgage—even when applying with a bad credit mortgage lender.
Before applying for a business loan, business owners should consider the reasons why a loan is required in the first place. Once a business plan is in place, a DTI ratio of 36 to 41% should secure a fair deal—especially in addition to high credit scores and a dependable debt service coverage ratio (DSCR), which is a measurement of a company’s available cash flow to pay current debt obligations.
A good debt-to-income ratio is anything below 36%.