When it comes to the ideal debt-to-income ratio, the lower it is, the better. Generally, you have the best chance of qualifying for a loan if your DTI is 36% or less.
| Debt-to-Income Ratio Ranges | ||
|---|---|---|
| DTI of 36% or less | You can comfortably afford your debt payments on your current income. Lenders will see you as a low-risk candidate. | |
| DTI of 37% to 41% | Your debt is manageable on your current income. Most lenders will view you as a low-risk candidate, but you may have trouble applying for loans of larger amounts. | |
| DTI of 42% to 49% | Your debt takes up a substantial portion of your income. While you may be able to qualify for some loans, it may be more difficult to qualify for another credit account. | |
| DTI of 50% or More | Your debt takes up half your income (or more), so lenders will view you as a riskier candidate. Since you may struggle to meet all your debt obligations, it may be harder to qualify for another credit account. | |
How to Calculate Debt-to-Income Ratio
Your DTI affects your loan eligibility. Before researching lenders, it’s a good idea to request a copy of your credit report and understand how lenders will view your DTI.
To calculate your DTI, follow these steps:
- Know your gross monthly income. This amount is how much you make each month before taxes and other deductions are taken out. You can determine this amount by checking your pay stubs or recent bank statements. Include income from your job, side hustles, tips, and any other recurring sources of cash.
- Identify your debt. Consider each of your accounts, including student loans, car loans, and credit cards. You can use your credit report – which you can access for free at AnnualCreditReport.com – to double check what accounts you have open.
- Add your monthly debt payments together. Find out what your minimum payment is for each of your accounts. Add them together to determine how much you pay toward debt every month.
- Divide your payments by your income. Divide the total amount that goes toward debt each month by your gross monthly income.
- Convert the result. Multiply the resulting number by 100 to get a percentage.
For example, Jerry earns $5,000 per month in gross income, and he has the following accounts:
| Accounts | Monthly Payment |
|---|---|
| Auto Loan | $350 |
| Student Loan | $500 |
| Credit Cards | $250 |
| Total Debt Payments | $1,100 |
In total, Jerry pays $1,100 toward his debt every month. To calculate his DTI, Jerry divides that amount by his gross income – $5,000 – and the result is 0.22. To convert that result to a percentage, he multiplies it by 100. By doing so, he finds that his DTI is 22%. From a lender’s perspective, he has an excellent debt-to-income ratio.
What is the Debt-to-Income Ratio Used For?
In addition to factors like your credit score and income, lenders take your DTI into consideration when you when you apply for a credit card or loan. DTI becomes particularly important when you apply for a loan to buy a home, since mortgage lenders have strict DTI guidelines to follow.
For example, Fannie Mae – a government-sponsored organization that is a leading source of mortgages – has different requirements for borrowers with DTIs of 36% or less and for those with DTIs of up to 45%. If you have a DTI of up to 45%, you’ll need a higher credit score and more cash reserves in the bank to qualify for a mortgage. If your DTI is over 45%, it’ll be more difficult to find a lender who will work with you.
How You Can Improve Your Debt-to-Income (DTI) Ratio
If your DTI is higher than the recommended debt-to-income ratio, here are some things you can do to improve it:
1. Increase what you pay monthly toward your debt.
One way to lower your DTI is to use the debt snowball method to repay your debt. If you have any extra money, put those dollars toward the account with the smallest balance. Alternatively, you can focus on paying down your debt with the highest interest rate first.
Though paying more toward your debt won’t lower your DTI right away, it can help you over time. By paying a little extra each month, you can pay off an account faster. You’ll have a lower DTI once one of your debt payments is eliminated.
2. Avoid taking on more debt.
Every time you open a new account, you add another monthly payment to your credit report that increases your DTI. Avoid applying for new forms of debt – such as credit cards or loans – until you’ve lowered it.
3. Consider debt consolidation.
If you have relatively good credit, one way to lower your DTI is by consolidating your debt. For example, some credit cards offer special promotions, such as a 0% annual percentage rate (APR) for 18 months. You can move all your outstanding debt onto the card, so you only have one monthly payment with little to no interest charges. Once the promotional offer expires, however, the regular APR will apply.
By consolidating, you may be able to get a lower monthly payment – that will also lower your DTI – or a lower interest rate which will help you pay off your debt faster.
4. Enroll in an income-driven repayment plan.
If you’re having difficulty making your federal student loan payments, federal loan borrowers can potentially improve their DTI by enrolling in an income-driven repayment (IDR) plan. With IDR plans, your loan payments are recalculated based on a longer loan term – 20 or 25 years – and a percentage of your discretionary income. By doing this, some borrowers can drastically reduce their payments.
Once your enrollment is complete, lenders will use your new monthly payment to determine your DTI. With a smaller monthly student loan payment, you may be able to lower your DTI.
5. Refinance your loans.
If you have multiple student loans, another way to lower your DTI is through student loan refinancing. When you refinance, you work with another lender to consolidate your existing loans into one. If you have a good credit score and reliable income, you may qualify for a loan with a lower interest rate and lower monthly payment than you have now.
Student loan refinancing can help you save thousands of dollars over the life of your loan, and your DTI may be lower too. How does it work? Consider Jerry from the example above.
Jerry has $45,000 in student loan debt at 6% interest and a 10-year loan term, giving him a monthly payment of $500 per month. He refinances his loans and qualifies for a 10-year loan at 4.5% interest, and his new monthly payment is $466. After refinancing his debt, Jerry would save nearly $4,000 over the life of his loans thanks to the lower rate.
Because his monthly payment decreased from $500 to $466, his DTI also improved. With his new payment, he pays a total of $1,066 toward his debt ($350 auto loan payment + $466 student loan payment + $250 credit card payment=$1,066). Divide that by his gross income – $5,000 – and you get 0.2132. By refinancing his loans, he lowered his DTI to 21.32%.
Tip: Remember, refinancing federal student loans can have some drawbacks, especially if you want to take advantage of IDR plans or federal loan forgiveness programs in the future. Carefully weigh the benefits of refinancing against the disadvantages to decide if it’s right for you. If you want to see how student loan refinancing would affect your monthly payments, use this student loan refinance calculator.
Monitoring your progress
If you plan on buying a home or taking out a loan, focus on lowering your DTI as much as possible to improve your chances of qualifying for a low-interest loan. Check your progress by reviewing your credit report every quarter and calculating your DTI. Over time, your DTI should decrease as you pay down your debt.
Learn more: Do student loans build credit?
