- Learn what is a good debt to income ratio
- See WHY you need to have a good debt to income ratio
- Learn how to improve your DTI by paying off debt fast.
Truth be told, when I bought my first townhouse I was 23 and had only been in the workforce for 10 months.
I had no clue what the heck I was doing when it came to buying a home, but luckily my mom had experience buying and selling homes so I had her to fall back on.
However, getting a pre-approval letter and lending after the housing crash of 2008 made it a pretty complicated situation.
Lenders were stricter with their lending policies, and they wanted to see at least one year of steady work on a tax return, in addition to a whole slew of other “Check the box type” things.
But here was the real kicker when it came to procuring lending…
The banks wanted to know my debt to income ratio.
And honestly…I had no clue what they were talking about. And for many, is is all too common, which is why today we will explore debt to income ratios including answering the question, “What is a good debt to income ratio!”
What is a debt to income ratio?
When my mortgage lender told me that she was concerned about my “Debt to income ratio,” I truly had no clue what she meant.
Evidently buying a new car was a pretty dumb move, and if I was going to buy a house I was going to have to put more down then expected.
She explained that your debt to income ratio, or “DTI” is the total of all your monthly debt payments divided by your monthly gross income.
This number, which is a percentage, is used to determine lending limits by banks for big-ticket purchases – typically houses and cars. Lenders want to ensure that if they lend consumers money, they can pay it back.
Related: How to Stop Overspending
Calculating your debt to income ratio is fairly simple.
How to calculate your debt to income ratio:
Calculating your debt to income ratio isn't overly complicated, the simple formula is:
DTI = total monthly debt payments/gross monthly income
In order to figure out what your current debt to income ratio is to follow these steps below or use the DTI graphic:
- Add up all of your monthly minimum debt payments.
- For example, $400 car payment, $50 credit card payment, $250 student loan payment and $1200 mortgage equals $1,900 in monthly minimums towards debt
- Next, divide by your gross monthly income, for example, $3,600
- In this scenario, $1,900 divided by $3,600 would equal 52%, meaning 52% of their gross income goes towards their debt each month
- In this example, if this hypothetical person wanted to procure lending for let's say another home – they would be over the desirable 43% limit lenders look for.
What is a desirable debt to income ratio score?
Comprehensive mortgage lending studies have led the lending industry to rest on a DTI score of 43% as the max. This is the highest ratio of debt to income a borrower can have for a qualified mortgage without having to use other means (Co-signer, paying off something, etc) to secure lending.
This doesn't mean you can't secure lending, it will typically just be more challenging.
Here is what a good debt to income ratio score looks like:
- 10% or lower = you most likely have no challenge with bills and have low debt
- 15% = you're good at managing your finances
- 20% = over 1/5 of your gross income each year goes towards debt
- 30% = one-third of your gross income goes towards debt payments
- 36% = 36% or lower marks the ideal number for lenders, however;
- 43% = the max DTI most lenders will lend up to
- 50% = Half of your money goes to debt, it might be time to pay off some debt.
Why is your debt to income ratio so important?
When a lender is considering whether or not to lend money, they want to make sure their investment will be worth the return.
In order to be as certain as possible, studies have shown that 43% is about the most sustainable amount someone can pay towards debt each month.
According to the Consumer Financial Protection Bureau,
Evidence from studies of mortgage loans suggest that borrowers with a higher debt-to-income ratio are more likely to run into trouble making monthly payments. The 43 percent debt-to-income ratio is important because, in most cases, that is the highest ratio a borrower can have and still get a mortgage.
Just how doctors have certain criteria for determining health conditions, lenders and baning intuitions have their marks. However, knowing your debt to income ratio is actually a good personal finance habit.
A good DTI ratio is an important goal to strive for. When the doctor recommends something to improve your health, you do it. Your debt to income ratio is a great tool to assess your financial stability.
You might make money, but if its all going out to debt, then that isn't good.
Your Score Increases Financial Awareness.
By lining up your monthly debt payments and then figuring out what percent your debt accounts for when compared to your monthly gross income, you quickly realize a few things.
For one, the expensive car payments do matter. Sure, you can probably afford a new car. But something most financial planners still stand by is the “Cash is King” motto.
Nothing hurts cash flow like a $400, 72 month car loan.
Throw in some credit cards, a student loan here or there and all of a sudden, if your percentage creeps up towards 36% you are entering a danger zone when it comes to lending.
However, knowing that your DTI score is too high, you can make adjusments to improve you debt to income ratio. Here is how:
How to fix your debt to income ratio:
1 – Line up Debt
First, line up your debt and come up with a plan to pay off the smallest debt payment ASAP. Paying off a $100 minimum payment could be the 4-8% you need to land lending.
Paying off the smallest debt will free up cash flow which helps your DTI score. This method of paying off debt commonly referred to as the debt snowball method.
2 – Cut Up Credit Cards
Cut up your credit cards and stop using plastic (if applicable) to help you avoid taking out more debt. If you're credit cards are paid off, simply cancel your cards.
If you owe outstanding balances on your credit cards, pay them off to help improve your debt to income ratio. Get in the habit of using cash to avoid taking out more debt.
3- Assess transportation costs.
It is time to be honest with your car, because it could be hurting your finances more than you might think. Start by asking these questions:
- How much does your transportation costs each month add up to?
- What percentage of your monthly budget does your car eat up?
Ideally, you want your car to be valued at no more than 25% of your annual gross income. Another way of looking at it is to make sure only 10% of your monthly budget goes towards transportation.
If your car is costing too much each month, it might be time to downsize your vehicle to something more affordable.
4 – Refinance Student Loans
If you're looking to get lending and improve your debt to income ratio quickly, you should consider refinancing your student loans.
While refinancing isn't a one size fits all solution, extending loan terms and reducing the monthly payment can be the difference in a few percentage points you may need for your DTI score.
Keep in mind there are pros and cons to refinancing student loans and it's always best to make sure refinancing fits your financial goals.
5 – Increase Cash Flow
The first four tips for creating a better debt to income ratio consisted of paying off debt and/or minimizing debt.
On the other side of coin, you can make more money, AKA increase your cash flow by getting another job, creating a part-time business, or working a side hustle that is recorded on your annual tax forms.
Some quick money making ideas include:
- Walking Dogs
- Check out these $1,000+ per month side hustles
- Filling out surveys to make $50 a week
- Using spare change apps to help pay off debt
- Use this for a full list of side hustle ideas
My Take On A Good Debt To Income Ratio
Want to ruin your Debt to Income Ratio? By a car at 22 right after you graduate college.
While this was my personal experience, buying the new car 6 months after graduating from college almost prevented me from securing lending for my first home because of my poor debt to income ratio.
As I alluded to earlier, since I was trying to purchase 2 years removed from the housing market collapse, the lenders were not going to budge on their criteria.
My car wasn't the only issue, my $40,000 student loan balance was also a problem as nearly $500 per month we're going to my student loans each month, (another reason to pay off student loans as fast as possible).
Even though I really deserved my car for all the hard work I did in college, it was a really dumb move. You see my debt payments – car and student loans – compared to my monthly gross income mattered when it came to buying a home.
Had I known that mattered, I would have never bought the car. I realized not just millennials, but all people, might not really understand debt to income ratios until they sit down to get lending.
At the end of the day, lenders want to make sure you can manage the monthly payments for the loan you are about to finance.
So that means you need to make sure you are working to improve your debt to income ratio at all times using the tips above!
Question: What is your current debt to income ratio?
New home purchase tip: Estimate your mortgage and save that amount for 6 months to get used to “Paying your monthly mortgage!”
Josh writes about ways to make money, pay off debt, and improve yourself. After paying off $200,000 in student loans with his wife in less than four years, Josh started Money Life Wax and has been featured on Forbes, Business Insider, Huffington Post and more! In addition to being a life-long entrepreneur, Josh and his wife enjoy spending time with their chocolate lab named Morgan, working out, helping others with their debt and recommend using Personal Capital to track your finances.