What Is Debt-to-Income Ratio
Debt-to-Income Ratio: What is it and how does it affect you?
Debt-to-income (DTI) is the ratio a lending agency will employ to determine whether you get a loan or not. You may not have realized it, but DTI is just as important as your credit score. To determine your DTI, take your monthly debt payments and divide it by your total monthly net income from all sources.
For example, you make $48,000/year net, which breaks down to $2000/month. Each month you spend $500 on debt (unsecured and secured). 500 divided by 2000 equals 0.25. Now take 0.25 and multiply it by 100 and you get 25%. So your debt-to-income is going to be 25%, which is well within the acceptable range.
For your information, lenders will typically follow the following ranges to determine if you are loan worthy:
If you are 35% or less your debt load is well within the manageable range. Keeping your debts under 35% of your income will demonstrate you are responsible, have wise and frugal spending habits, and are thus worthy of credit.
Between 36% and 41% debt-to-income ratio is when most people begin to feel a pinch. Though we are accustomed to shouldering more debt than our parents or grandparents, the fact is that anything above 35% puts a borrower in a more precarious position.
42%-49% will cause nearly all but the most fearless of lenders to avoid you like the plague. At this point, you’re probably keeping up with your payments and keeping your accounts current -but just barely. Any smart lender is going to understand that granting you any more credit- i.e. potential debt- is a huge risk.
50% and above and you might as well forget about it. The only responsible thing to do is seek help from a debt management company or some kind of consolidation loan to lower your debt-load.
How you can improve your DTI?
So you’ve calculated your DTI and it is well above an acceptable range. What are some of the ways you can improve your DTI and make you more attractive to lenders and creditors?
Obviously, it would be nice if we could all answer this question by going out and getting that big raise and promotion, winning the lottery, or coming into a large inheritance. A pragmatic person isn’t going to rely on fate or luck, but instead will take concrete action and progress towards decreasing debt as quickly as possible.
One of the first ways to do this is to find areas in your budget where you can cut costs. Any savings you can wring out should immediately go towards your higher-interest debts like credit cards. As long as you have those credit cards in your sites, you can adopt a policy of doubling-up on your monthly payments. In other words, if you owe a minimum payment of $50, pay $100.
Another effective way to improve your DTI goes without saying, but so many people forget it: stop charging. All the money in the world isn’t going to make your debt go away if you keep adding to it.
Then there’s the unforeseen expense, say your car’s transmission goes out or your refrigerator dies. Bad things happen and they’re often expensive but if you’re smart, you’ve already got a place in your budget where you tuck away a little “just in case” money. You may have not have realized it but you’ve already taken a large proactive step towards helping your DTI.
It’s also best to avoid large purchases. It can be hard, say, if you’ve just tapped into your “just in case” fund to fix your car. You might even think it’d be nice to have a new car. But if you can hold off, you should. You might think you can easily afford the $200/month car payment but remember, that’s $200 you could be saving or applying towards your remaining debt.
Finally, when all other avenues fail, seek help from a financial adviser who will be able to get onto some debt management plan and headed in the right direction.
In the end, it’s all about leverage. By adjusting your lifestyle and your budget, you increase the likelihood banks and lenders will loan to you. Back when your DTI was way above 35%, you wanted that new car but nobody would lend to you. Once your DTI is within the acceptable range, you are equipped with a powerful tool that will help you negotiate loans even if your final credit score and other determining factors weigh against you.