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There are many different metrics you can use to determine how well you’re doing financially. One of the most effective for determining credit worthiness (and most commonly used by lending agencies) is the debt to income ratio or DTI ratio.
In a perfect world, the ideal debt to income ratio would be 0% (absolutely no debt).
However, for most of us, that’s not realistic as there are large expenses that we couldn’t fund in a reasonable amount of time without the use of credit. These include mortgages, small business loans, etc.
Just because we have access to credit and need it (arguably) for large purchases, you shouldn’t abuse it. Checking a few key metrics like your net worth and debt to income ratio can give you a quick snapshot of how you’re handling credit.
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What is a Debt to Income Ratio?
A debt to income ratio, or DTI ratio, is derived by dividing monthly debt payments by monthly gross income. It’s expressed as a percentage and used by lending agencies to see how you currently handle your monthly debts and how much more debt you can afford to borrow.
The higher your debt to income ratio, the more of a risk you are to lending agencies.
For a simple example, let’s say you have two family members asking for money. One makes $100,000/year; the other $60,000/year. They both live in equally priced houses and have equal amounts of debt. Who would you be less likely to lend money to? (spoiler – the family member making $40,000/year less).
How to Calculate Your Debt to Income Ratio
To calculate your debt to income ratio, it’s pretty simple.
- Add up all of your monthly debts. This includes:
- Mortgage payment
- Real estate taxes and home owner’s insurance payments (if escrowed)
- Minimum credit card payments
- Car loan payments
- Student loan payments
- Personal or business loans payments
- Monthly child support payments
- Monthly alimony payments
- Co-signed loan monthly payments
- Any other debt listed on your credit report
- Determine your monthly gross income. This is the amount you receive before anything else is taken out including taxes, insurance, retirement, etc. This includes:
- Wages
- Salaries
- Tips and bonuses
- Pension
- Social security
- Child support and alimony
- Any other additional income
- Divide your monthly debts by monthly gross income.
- Multiply this number by 100 to make it a percentage. You now have your debt to income ratio!
Debt to Income Ratio Limitations
Although your debt to income ratio is a good check on your financial health, it does not take into account your full financial picture. It does not factor in your other monthly expenses like food, gas, utilities, insurance, healthcare expenses, daycare, etc.
Probably the best example where the debt to income ratio has failed most people is in how much money they’ve been approved for mortgages.
For example, let’s say you earn $6,000/month gross and have debt payments of $1,500/month. Using these numbers, you would have a debt to income ratio of ~25%. Most mortgage companies will approve you with a debt to income ratio anywhere from 36% to 43%, so let’s say they approve you for a mortgage payment up to $900/month. If you utilize the full funds available, this would be a debt to income ratio of ~40%.
This would be fine if it was the whole picture, but it’s not. Let’s say taxes take out $900/month. You also have two young children that require daycare at $700/month each ($1,400/month), utilities that cost $400/month, gas at $200/month, food at $800/month, and insurance at $300/month. That’s $4,000/month that you are spending on items not included in debt. When you combine this with the $1,500/month you are spending on debt payments, you really only have $500/month to spend on mortgage payments.
In this scenario, if you had used the maximum approved by the mortgage company you would be losing money each month unless you tightened up your expenses (things you can control like food, utilities, etc.).
Create a Simple, Monthly Household Budget
To truly know where you stand financially, you need to create a simple monthly household budget.
To create a budget, you first need to determine what your financial goals are, and what your gross monthly income and monthly expenses are. T
his information allows you to see how much money you have, how you’re spending it currently, and, taking into account your financial goals, create a budget that tells each dollar where to go each month.
This gives you complete control of your finances and allows you to be in control of your financial destiny.
To learn more, please read: How to Create a Simple Monthly Household Budget
What is the Ideal Debt to Income Ratio?
From a lender’s perspective, 36% and lower is considered a good debt to income ratio. For someone who wants to get ahead financially, you need your debt to income ratio to be as low as possible. The best debt to income ratio is 0% (nothing, nada, no debt).
When working towards getting ahead, you should strive to pay down debt as fast as possible because it is standing in your way. Having debt is like wearing financial handcuffs.
It is keeping you from saving and investing for the future.
Keeping you from starting that small business you’ve always dreamed up starting.
It is a roadblock on your way to financial freedom.
Debt is the enemy and needs to be eliminated.
Does Your Debt to Income Ratio Affect Your Credit Score?
Your debt to income ratio doesn’t directly affect your credit score. However, your credit utilization ratio makes up ~30% of your score. The higher the ratio of current balance to original amount for credit cards, loans, etc. the more it hurts your score.
For instance, if you are currently utilizing 80% of your available credit, you are sending a signal to lenders that you are high-risk because you are using the majority of credit you already have access to.
How to Lower Your Debt to Income Ratio
When it comes to lowering your debt to income ratio, there are only two variables in the equation, your debt and your income. To lower it, you need to lower the amount you pay each month in debt and/or increase the amount of income you have coming in each month.
Lowering Your Debt
- Create a budget. Utilize the 50-30-20 budgeting rule as a guideline.
- Create a plan for paying down your debt. Popular strategies include highest interest first and debt snowball (smallest debt first)
- If most of your debt is high interest debt, you may be able to refinance or consolidate to get better rates. Be very careful, as these folks aren’t providing this service out of the kindness of their heart. They need to make a profit, so their offer may be worse than what your currently have. A lower monthly payment, but higher overall cost in the long run is not okay if you want to build long-term wealth.
- For more information, read: Which Debt Should You Pay Off First?
- Avoid taking on more debt
Increasing Your Income
- Work overtime
- Ask for a raise at work (if you deserve it)
- Take on a second job
- Earn extra money with a side hustle
Your debt to income ratio is a quick metric you can run to see how you’re handling debt. It has its limitations as it doesn’t factor in any non-debt related expenses (daycare, food, utilities, etc.). Most lenders look for a debt to income ratio below 36% when determining eligibility and amount they’re willing to lend (some go as high as 43%). However, the ideal debt to income ratio for everyone is 0%. This is what you should be striving to reach (if you haven’t already!).
Have you improved your debt to income ratio? How much did you improve it and by how much?