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What is the debt-to-income ratio & why does it matter?

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The Good Brigade/Getty Images

The debt-to-income ratio (DTI) is one of many factors lenders consider when deciding if you qualify for a loan or line of credit. Understanding your DTI gives you the power to use your strong financial history to your advantage.

If your DTI needs some TLC (tender loving care), don't worry. There are ways to improve it. Let's discuss what you need to know about this critical number.

What is the debt-to-income ratio?

Your DTI represents how much debt you owe compared to how much income you earn. It's typically expressed as a percentage of how much of your income is tied up in debt payments.

The lower your DTI, the better. A low debt-to-income ratio means after making your debt payments you still have income available to cover other needs or build savings.

How do you calculate your DTI ratio?

To calculate your DTI, take the sum of your monthly debt payments divided by your monthly income before taxes.

Debt-to-income ratio = [sum of monthly loan payments] ÷ [monthly income before taxes]

Monthly debt payments would include those that need to be paid every month, things that appear on a credit report (loans, credit card payments, alimony, child support payments.) It does not include monthly bill payments for living expenses.

For example, let's say you have a mortgage that is $1,800 a month, a car loan that's $350 a month and a credit card payment that's $100 a month. Your total monthly loan payment is $1,800 + $350 + $100, or $2,250. If you earn $8,000 a month, you'll calculate your DTI using this equation.

$2,250 monthly loan payments ÷ $8,000 gross income before taxes = 0.28 Multiply your DTI by 100 to get the percentage.

0.28 x 100 = 28% DTI

Consider calculating your DTI before applying for a mortgage or other type of loan to make sure you meet lenders' qualifications and are only borrowing what you can afford.

What is a good debt-to-income ratio?

Although the exact number may vary by company, lenders generally follow these guidelines to define a good DTI:

  • DTI of 35% or less = good. With 35% of your monthly income going toward debt payments, 65% is available for any other expenses and any new loan you're applying for. A lender may feel confident in your ability to repay a new loan successfully.
  • DTI between 36% and 45% = OK. You still may qualify for a loan with a DTI between 36% and 45%, but the loan could come with higher rates and fees. Consider paying down some of your debt to lower your DTI.
  • DTI over 45% = needs work. If more than 45% of your income is devoted to debt payments, you may have a hard time getting approved for a loan. Repaying the loan might be difficult even if approved since so much of your money is tied up in debt. Try making adjustments like paying off high-interest credit card debt or seeking a smaller loan.

Overall, a good DTI can make it less costly to borrow, so it's worth putting in the work to get your DTI into a healthy range.

Why is the debt-to-income ratio important?

Many lenders view the DTI as a measure of financial stability and use it to help determine your ability to repay the loan. A high DTI could indicate that you don't have the financial capacity to take on a new loan. Lenders often view this as a signal of a high-risk borrower.

To cover the risk of you being unable to repay borrowed funds, lenders might charge more interest for a loan or offer other less favorable terms. If your DTI is too high, the lender may deny the loan application altogether, fearing you won't repay the debt.

A low DTI shows that you likely have the resources to repay your loans. A lower DTI can result in greater approval odds and lower interest rates.

Keep in mind that your DTI is one of several numbers that paint a picture of your financial health. If you have a high DTI, you're not necessarily doomed. You may be able to offset it with a good credit score, and there are also steps you can take to move your DTI in a positive direction.

How does DTI differ from a credit score?

DTI ratios and credit scores are two different numbers that help lenders decide whether to approve you for a loan and at what terms.

Your DTI measures your debt compared to your income and is expressed as a percentage. The lower your DTI, the better.

Your credit score measures your overall creditworthiness to gauge the likelihood you'll repay your debts. Different factors go into how credit scores work. Your total debt, how many open accounts you have, the length of your credit history and your payment history are combined in weighted amounts and then rated with a number between 300 and 850. The higher your credit score, the better.

Balancing your DTI and credit score

Although your DTI and credit score are different, they're both important in determining your borrowing power. Here's what the combination of these factors typically signals to lenders:

  • Good DTI, good credit score: This shows that you have borrowed and repaid your debt with no issues and with enough income to cover other bills and obligations.
  • Good DTI, poor credit score: Your debt doesn't take up an overwhelming portion of your income, but late or missed loan payments or a short credit history could leave lenders hesitant to approve your application.
  • Poor DTI, good credit score: Although having good to excellent credit may mean you've repaid debts responsibly, a low DTI could signal you've already borrowed as much as you can afford to repay.
  • Poor DTI and poor credit score: This may signal you've struggled to borrow and repay loans currently and in the past.

How to lower your debt-to-income ratio

If your debt-to-income ratio feels high, you're not alone. Across the U.S., total debt for mortgages, credit cards, and auto loans has increased significantly since 2020, according to data from the Federal Reserve Bank of New York. But, it is possible to improve your DTI. Here's how.

Aggressively pay down your current debt

Putting more toward your debt to pay it down or pay it off not only will lower your DTI, but it also can improve your credit score.

Refinance existing debt

Refinancing for a lower interest rate or a longer repayment period could lower your debt-to-income ratio.

  • A lower rate could lower your monthly payment, meaning less of your income will go toward loan payments. A low rate also makes it easier to pay down the debt.
  • A longer repayment period could cost you more in the long run because the loan has more time to accrue interest. Still, the immediate impact would lower your monthly payment and DTI ratio.

Look for ways to increase your income

Debt is only one side of the DTI equation. Increasing your income will improve your DTI. Whether you find a higher-paying job or add a side hustle, the extra money can help you pay down debt.

Expert help for your overall financial health

Keeping a healthy debt-to-income ratio, around 35%, will ensure you're borrowing what you can afford and can increase your chances of getting the best loan terms. But sometimes, it's easier said than done. Use the steps above if you need to lower your DTI and remember that it is one of many numbers to manage for overall financial health.

For help with your financial big picture, connect with a Thrivent financial advisor to get expert guidance in setting and reaching your goals.