How important is your debt-to-income ratio? Most financial institutions have a rigorous process before approving any type of loan.
There are several factors they take into consideration to weigh the risk and benefit of lending an individual money.
Your credit score is heavily weighed as well as an intense review of your credit report. (If you need to work on your score, check out 5 Ways to Improve Your Credit Score Fast for tips.)
However, many people do not know that their debt-to-income ratio is also a heavily weighted factor.
According to Debt.org, the average debt-to-income ratio in America hovered around 12% for 2021, as a household making $59,000 on average has a debt of $4,910.
This is encouraging as this number is low in the eyes of lenders.
Let’s take a look at how to find one’s debt-to-income ratio and what’s a good debt-to-income ratio to qualify for a loan at a good interest rate.
When you want to see where you stand among the rest of consumers financially, there are different ways to measure yourself.
A credit score and credit report offer a picture of all past and present debt that you’ve managed but your debt-to-income ratio focuses primarily on the present status of your finances.
In a way, your debt-to-income ratio is a way to measure your financial ‘fitness.’
If you’re financially fit, your DTI is a low percentage and if you are at risk for financial woes, your DTI is a high percentage.
How to Calculate Debt-to-Income Ratio
Although it may seem self-explanatory, your debt-to-income ratio involves only part of your debt and includes all of your income.
This may sound confusing but it’s a pretty simple formula for debt-to-income ratio once you’ve found those basic numbers.
The first step is to find your annual income. You’ll want your total income before taxes, insurance, and retirement contributions are taken out.
Next, you’ll need to find the total of all monthly debt payments.
When adding up these accounts, it is not necessary to add utility bills, as the formula uses only calculated debts that include credit cards, rent or mortgage, personal loans, student loans, and car loans.
Once you have those two numbers, you divide the debt number by the monthly income amount and multiply it by 100 to get your percentage.
It’s important to find your monthly income by dividing your annual income by 12.
If that is all too confusing, you can also plug the two numbers into a debt-to-income ratio calculator for quick results.
A few free online calculators you can use are listed below:
- Wells Fargo: Debt-to-Income Ratio Calculator
- Calculator.net: Debt-to-Income (DTI) Ratio Calculator
- Zillow: Debt-to-Income Calculator
If you would like a visual of the bigger picture of how to figure out your debt-to-income ratio, a worksheet might be best.
Some institutions such as banks and mortgage companies will have a debt-to-income ratio worksheet on their website for consumers to download.
It’s important to note that some of the worksheets may have contradictory information about what to include in the debt portion, but each one will give you a general idea of calculating your DTI.
In addition, every financial institution is slightly different in their calculations, but it won’t produce a huge difference in the final DTI percentage.
What’s a Good Debt-to-Income Ratio?
Zero debt is always the best, however everyone has necessary debt. If you want to build credit, you need to get a credit card or loan.
If you want a good credit history, you’ll need to hold on to those loans for a few years.
Since most people don’t have hundreds of thousands of dollars in the bank to pay for a house, a mortgage is a necessary debt.
It is extremely important to keep debt under control and managing your debt-to-income ratio is an excellent way to do so.
When you approach a lender for a loan, they will study your debt-to-income ratio. Most financial institutions like to see the percentage below 30%.
This isn’t great however.
What’s a good debt-to-income ratio is a percentage that hovers around or below 20%. Lenders will recognize that you know how to manage your debt within the limitations of your income and are much more likely to lend you money.
A high debt-to-income ratio is anything over 50%.
A percentage that high will give you the appearance of potential risk to lenders.
Depending on the size of the requested loan, bankers want to be assured that you are able to repay the debt within your income limitations and may not approve your request for a loan.
In addition, the lower your DTI, the better interest rate or promotional offer you will receive from lenders.
Conversely, when they approve individuals who are a potential risk, they harshly impose high interest rates and fees to cover themselves.
There are several ways to keep your DTI low and manageable.
It may not always be fun or convenient but there are ways to make cuts within your budget or increase your income.
A combination of both will certainly make your DTI percentage decrease much quicker.
- Cut out unnecessary entertaining, dining out, or expensive clothing purchases that will hurt your credit card balance.
- Decrease debt by revising your budget to pay off high interest loans first.
- Increase income by picking up side jobs after your normal work hours.
- If you must have name brand things, shop sales and use coupons.
- Try consolidating all debt into one payment with a low interest rate.
All of these tips put into action can help take your high debt-to-income ratio down to a range that will appeal to lenders.
After a couple months, you’ll discover a huge difference and can feel confident applying for that new loan.