Debt-to-Income (DTI) Ratio

What Is Debt-to-Income Ratio?

The debt-to-income (DTI) ratio is the ratio or percentage of your monthly debt payments compared to your total gross monthly income. In short, to calculate your debt-to-income ratio, you would divide your total monthly debt payments by your gross monthly income to get a percentage. For example, if you have $1,000 in monthly debt payments and $4,000 of gross monthly income, your debt to income ratio is 25%.

Detailed Look at Debt-to-Income Ratio in Personal Finance

Having a low debt to income ratio is a signal that you're less risky to lend money to because you have your overall debt in a good place. A low ratio might be considered 15% or less, and having a debt to income ratio under 15% could show lenders that you are effective at keeping your debt expenses low. 

Your debts can range anywhere from your mortgage payments, auto loan payments, or the minimum payments on your credit cards.

On the other hand, having a high debt to income ratio might cause lenders to be less likely to loan you money, or as much money, or at a low interest rate. That's because having a high debt to income ratio could show lenders that you are taking on too much debt for the amount of money you earn.

For the most part, lenders generally will no longer lend you money if your debt to income ratio exceeds 43%. That said, it's common for 36% or lower to be preferred, and no more than 28% of your debt to income ratio be your mortgage or rent.

In short, to have the highest chance of getting approved for a loan and at a lower interest rate, it's best to minimize your debt to income ratio as best you can.

Debt-to-Income Ratio Example

Anna wants to get a mortgage and, in order to do so, needs to know if her debt to income ratio is low enough to qualify.

Anna's monthly debts are as follows:

  • Credit card minimum payment: $80
  • Auto loan: $320
  • Rent: $1,200

Based on the above, Anna's total debt per month is $1,600

Anna sees that her gross annual salary is $96,000, or $8,000.

This means that Anna's debt to income ratio is $1,600 divided by $8,000, which is 0.2 or 20%.

How to Decrease Your Debt-to-Income Ratio

There are two ways to decrease your debt to income ratio.

Decrease Your Debt Payments

The lower your monthly debt payments are, the lower your debt to income will be. One example of this is to pay down a credit card aggressively, as the monthly minimum payment decreases as the balance decreases.

Refinancing a loan to a lower interest rate can also lower your monthly payments, which lowers your debt to income ratio.

Increase Your Income

Since the other side of the debt to income ratio is your gross monthly income, then it makes sense to say that if you increase your income, your debt to income ratio will go down. This is illustrated below.

If Joe has $1,000 in debt payments and $3,000 in gross monthly income, then his debt to income ratio is 33%. However, if Joe increases his gross monthly income to $4,000, then as a result, his debt to income ratio decreases to 25%.

Why Your Debt-to-Income Ratio Matters

Your debt to income ratio matters as this is one factor a lender may use before choosing how much money to lend you and at what interest rate. When you have a low DTI ratio, you generally appear less risky to a lender, whereas when you have a higher DTI ratio, you generally appear riskier.

What is a Good Debt-to-Income Ratio?

A lender will generally only lend money to someone who has a DTI ratio of up to 43%, however, it's more ideal to have a DTI ratio of 36% or less, with 28% being the highest debt going towards your rent or mortgage. 

Having a lower DTI ratio will generally make you look less risky to lenders, which can help in getting more money at better interest rates.

What are the Drawbacks of the Debt-to-Income Ratio?

The DTI ratio doesn't take into consideration the sources of your debts. Instead, it lumps all debts into one percentage compared to your total gross income. If you refinance a source of debt to a lower interest rate, your DTI ratio may decrease as your minimum payments could decrease, but your total debt owed would remain the same.