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You’ve kept a stable job over the past few years and worked hard to improve your credit. You are now ready to submit this loan request. Where are you?
In addition to your work history and credit, lenders will consider another important measure of financial health: the debt-to-income ratio, or DTI. Learn more about what your DTI means, how it’s calculated, and how to get yours in top shape.
What is the debt to income ratio?
Your debt-to-income ratio is a measure used by lenders to determine how much of your income is spent on debt repayment each month. It considers all of your monthly debt payments relative to your gross monthly income and is expressed as a percentage.
When you apply for a loan, lenders like to see a low DTI. This is a strong indication that you have enough cash to make your payments on time each month. A low DTI is also a good sign that you are in a solid financial position and can comfortably afford your lifestyle, whether or not you plan to borrow.
How to calculate the debt-to-income ratio
To calculate your debt-to-income ratio, start by adding up all of your monthly debt. This includes revolving credit, like credit cards and the like. Credit lines, as good as installment loans such as student loans, auto loans and personal loans. You should also include any child support or alimony payments that you are responsible for making each month. Usually, you don’t need to consider other expenses like food, utilities, and insurance.
Once you’ve tallied all of your obligations, divide that number by your gross monthly income (that’s what you earn before taxes, pension contributions, and other deductions). You’ll end up with a decimal fraction, which you can multiply by 100 to get your DTI percentage. The equation looks like this:
DTI = Monthly debts / Gross monthly income
For example, let’s say your debts are as follows:
- Credit Card A: $ 500
- Credit card B: $ 350
- Auto loan: $ 150
- Home equity line of credit: $ 200
- Student loan: $ 400
This gives you a total of $ 1,600 in monthly obligations. Now let’s say your gross monthly income is $ 5,000. You would calculate your DTI as follows:
$ 1,600 / $ 5,000 = 0.32
Multiply the result by 100 and you get a DTI of 32%. In other words, 32% of your gross monthly income goes to pay off debt.
Keep in mind that even if your DTI is considered low, other monthly expenses can eat into your budget. When you borrow money, it’s important to consider how these other costs might affect your ability to keep your payments under control.
Types of debt-to-income ratios
Typically, the above equation gives you your overall debt-to-income ratio. However, some lenders like to break this number down even further to find your front-end and back-end DTI. You will often come across these terms when applying for a mortgage.
Frontal DTI measures your housing costs or potential housing costs only against your income. Also called the housing ratio, this calculation takes into account your monthly mortgage payment, private mortgage insurance and the other costs associated with your home loan, divided by the gross monthly income.
DTI back-end is the most complete calculation. This version of the DTI examines not only your housing expenses, but all debt obligations such as credit cards and loans, divided by gross monthly income.
What is a good DTI report?
What counts as a “good” DTI will depend on the type of loan you want. Some lenders allow a higher DTI, while others require a lower threshold.
In general, lenders prefer that your back-end ratio does not exceed 36%. This means that if you are earning $ 5,000 in gross monthly income, your total debt should be $ 1,800 or less. However, some lenders can make an exception if you have excellent credit. In fact, it is possible to qualify for a loan with a DTI of up to 50% as long as you are an otherwise highly qualified borrower.
Mortgage lenders, in particular, tend to have stricter rules. They generally prefer a frontal DTI of 28% or less. This means that your mortgage payments cannot exceed 28% of your gross monthly income. So if you are earning $ 5,000 per month, your mortgage payments should not exceed $ 1,400.
On the other hand, conventional mortgage lenders, as well as FHA and USDA lenders, will typically allow a back-end DTI of up to 43%, giving your budget a little more leeway. VA loans typically require a back-end DTI of 41% or less.
Knowing your front-end and back-end DTI can help you understand how much house you can afford. If you are applying for a mortgage and the payments cause you to exceed any of these DTI requirements, you may need to go for a smaller loan or you may be turned down for a loan.
How DTI Affects Your Credit Score
Not only does your DTI impact your ability to get a loan, it also indirectly affects your credit. This means that even if you’re not trying to borrow money right now, too high an DTI could drop your credit score points and make it more difficult to secure an apartment or open an apartment. ‘a utility account.
The main reason DTI and credit are tied is that the total amount of debt you owe affects about 30% of your FICO score. The lower your debt amount compared to your available credit, the better your score. Conversely, the more debt you have in your name, the worse its impact on your score. So if you have a high DTI it follows that you are probably using up a significant portion of your available credit.
DTI can also have an impact on your credit if you owe so much that you are unable to keep up with your payments. As the most weighted factor in calculating your credit score, payment history accounts for 35%. A single missed payment can take several points off your score, so it’s important to keep your debt level manageable.
How to lower your DTI ratio
Generally, if you’re trying to lower your DTI, there are two things you can do: increase your monthly income or reduce your debt load. Here’s a closer look at how to achieve each of these goals:
- Increase your monthly income. Increasing your income is easier said than done. Yet, if reducing your ITD is a goal, finding ways to increase your salary is one way to do it. Maybe it’s time to negotiate a raise at work or work a few extra hours. You can also turn a hobby or skill into a lucrative business and generate extra income when your schedule allows.
- Lower your unpaid debt. Your other option is to get rid of some debt so that your monthly payments are lower (or better still, non-existent). Bonus at work? Tax refund? Use these deals to make additional lump sum payments on your debt. By reducing the amount you owe monthly, your DTI will also go down.