Debt-To-Income Ratio: How To Calculate & Lower Your DTI

While your credit score is an important factor for lenders, there’s another number you might not know that lenders are looking at: your debt-to-income (DTI) ratio.

Read on to learn everything you need to know about a DTI ratio, including how to calculate your debt-to-income ratio, what is a good debt-to-income ratio, how to lower your debt-to-income ratio, and more.

What Is The Debt-To-Income (DTI) Ratio?

The debt-to-income (DTI) ratio is a financial tool used to measure the relationship between a person’s debt and income. The DTI ratio is calculated by dividing recurring monthly debt payments by gross monthly income.

When applying for a loan, lenders look at your DTI to see if you can afford regular monthly payments based on your income and to determine how much of a risk you are.

The debt-to-income ratio is primarily used when applying for personal mortgages (though some other personal loans depend on your DTI as well). For small businesses applying for loans, greater value is placed on your debt service coverage ratio (DSCR).

However, the debt-to-income ratio is still important for sole proprietors and freelancers in need of financing. Sole proprietors aren’t legally considered separate business entities and therefore don’t have a DSCR; this means lenders will look at your debt-to-income ratio when considering your loan application.

Why Is The Debt-To-Income Ratio Important?

Your debt-to-income ratio is important for two reasons:

• It indicates how financially healthy you are.
• It plays a large factor in how likely you are to qualify for a loan.

Before applying for a loan, it’s important to consider whether you can actually afford one.

By calculating your DTI ratio, you can analyze how much existing debt you have and whether or not it’s financially wise to take on more, considering your monthly income. In addition, figuring out your DTI ratio will help you determine how much debt you can realistically take on.

If you have too much debt or too little income, taking on more debt might not be the right option, at least not until you lower your DTI. Knowing your DTI ratio before you even start talking to potential lenders will save you a whole lot of trouble.

If your debt-to-income ratio is too high, lenders may reject your loan application because you’re too high of a risk. If your DTI is low, lenders are more likely to approve your loan because they trust that you will be able to pay back your debt.

Here are some of the key benefits of a low debt-to-income ratio:

• More likely to qualify for a loan
• More likely to receive an offer with better loan terms
• Increases your chances for lower interest rates and higher loan amounts
• Can potentially afford to take out multiple loans
• Less stress and worry about if you can make your monthly payments

For small businesses, your personal DTI also has a role to play. While most predominantly look at a small business’s debt service coverage ratio (DSCR), many lenders also evaluate a business owner’s DTI, both to affirm your trustworthiness and to ensure that you can personally guarantee your business loan if no other collateral is provided.

The bottom line? DTI is incredibly important for individuals and business owners alike.

How To Calculate Your Debt-To-Income Ratio

To calculate your debt-to-income ratio, you’ll need to divide your total recurring monthly debt payments by your gross monthly income. The DTI is always expressed as a percentage.

This is the DTI ratio formula:

Total Monthly Debt / Gross Monthly Income = DTI

But how do you determine your total monthly debt and gross monthly income?

What Is A Good Debt-To-Income Ratio?

When it comes to DTI ratios, the lower, the better. A low DTI indicates that you can comfortably take on a loan and make your monthly payments, which means you are more likely to be approved by lenders.

A higher DTI indicates that you may struggle to cover monthly payments, making it more difficult to qualify for loans.

While accepted debt-to-income ratios vary by lender, in general, a DTI of 36% or lower is considered a good debt-to-income ratio.

Mortgage lenders often stick to the 28/36 rule (they’ll give you a loan so long as your DTI is below 36% with no more than 28% going toward the mortgage).

Many lenders will finance (up to) a 43% DTI, albeit with less favorable rates and terms. If your DTI is higher than 43%, you may have a hard time getting approved for a loan. You should consider lowering your DTI before applying.

For this reason, it’s important to research each lender’s specific qualifications and strive to keep your DTI as low as possible. This will both increase the likelihood of getting approved for a loan and give you peace of mind about your financial health.

Using DTI To Determine If You Can Afford A Loan

Not only does your DTI tell you if you can afford a loan, it also helps determine the amount you can afford.

Let’s return to our example from earlier. We calculated your current debt-to-income ratio at 14%.

If you want to keep a good debt-to-income ratio, you don’t want your total DTI ratio to exceed 36%. That means a potential mortgage can take up 22% of our total debt-to-income ratio (36 – 14 = 22).

We can now use this number to determine the size of the mortgage loan payment you could afford each month. Simply multiply your gross monthly income by 22%.

3,500 x .22 = 770

If you want to stick to a 36% DTI, you can afford to pay $770/month on your mortgage while still making your other monthly loan payments and covering everyday expenses.

If you approach a potential lender knowing exactly how much you can afford to pay each month, you can avoid being pressured into borrowing more than you can afford.

How To Lower Your Debt-To-Income Ratio

There are several ways to lower your debt-to-income ratio:

• Increase your monthly income
• Pay off some of your debt
• Decrease your borrowing amount

Increasing your income is a good way to lower your debt-to-income ratio, though this option doesn’t always seem achievable. While not ideal, you can always consider starting a side hustle to bring in more additional income.

Decreasing your debt is another viable option. Carefully evaluate your budget. Cut unnecessary expenses and allocate that money to paying down your debt instead. Depending on your financial situation, consolidating your debt might also be a good option.

If you’re applying for a mortgage loan, you can also make a larger down payment, which will lower your monthly payments and, in effect, lower your DTI ratio.