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If you’ve ever applied for an auto, home, or personal loan, you may have heard your financial institution mention your debt-to-income ratio. Your debt-to-income (DTI) ratio is the amount of all your monthly debt divided by your gross monthly income. This ratio is used by lenders to determine your ability to manage all of your monthly payments to repay the money you borrow.
Why? Studies of mortgage loans have shown that borrowers with a higher DTI are more likely to have trouble making payments. Because their budget is more tied-up, when other unexpected costs arise, those with a tighter budget (i.e. more debt expenses) will have less wiggle room to afford both debts and life’s unexpected challenges.
Calculating your DTI is simple. Just add up all of your monthly debt payments; this includes credit cards, auto and mortgage loans, personal loans, and student loans. Then, divide this number by your gross monthly income and you will accurately calculate your DTI.
Here is an example of a DTI calculation:
Total monthly debt obligations: $2,550
Total gross monthly income: $6,000
Debt-to-income ratio = 2,550 / 6,000 = 42.5 %
Of course, upon calculating DTI, a common next step is to understand what your ratio means – is it low or is it high?
What your DTI Ratio Means
Generally speaking, 43% is the maximum DTI a lender will approve for a qualified mortgage loan. A reasonable DTI is considered under 36%, while most consumers feel more financially comfortable around 30%.
There are many reasons why we should have some debt. In fact, a reasonable amount is healthy – providing more buying power in the marketplace. However, a high DTI can affect you in more ways than one.
1. You may have issues getting loans
Even if you have a great credit score, a high DTI may hinder you from being approved for even small loans. This is because lenders want to ensure you can easily afford monthly payments before they extend credit to you.
2. You may be financially stretched
With a high DTI, you may find yourself living paycheck-to-paycheck. Moreover, each paycheck is carefully budgeted, with little room for unexpected expenses.
3. If you lost your income, you could ruin your credit
Because those with high DTI have high monthly bills and a tight budget, those in that financial position could become quickly unable to make payments upon loss of income. This means missed payments and dings on credit. The lower your monthly bills, the easier it is to survive if the unthinkable were to happen.
For this reason, it is very important to have an established emergency fund. Emergency funds are the best way to ensure you have the funds you need when life gets a bit out of control. Be it a medical emergency or a layoff, be prepared for life by saving each month.
Looking to lower your DTI?
Lower your DTI by decreasing the amount of credit you use and by paying off your debt as you are able. Student, auto, and mortgage loans are harder to payoff, so refinancing is the best option if these monthly payments seem too high. Focusing on paying off credit cards and personal loans is usually easier and more appropriate as these loans also tend to have higher interest rates.