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What is a Good Debt to Income Ratio, and How to Calculate Yours
A good debt-to-income ratio is one where your monthly income exceeds your monthly debt payments. If you’re looking to get a loan or a mortgage, your debt-to-income ratio will likely be checked to evaluate your eligibility. Calculating your debt-to-income ratio can help predict if you’ll be approved. It can also determine if you’re ready to take on new debt, or if you should pay some off first. Continue reading to learn more about a good debt-to-income ratio and how to calculate yours!
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What exactly is a debt-to-income ratio?
A debt-to-income ratio (DTI) is a percentage that compares your debt, including student loans, to your annual income. This number is one of the ways lenders measure your ability to manage the monthly payments to repay the money you plan to borrow. Lenders will consider your DTI when evaluating your eligibility for a loan or new line of credit. Lenders find applicants with a low ratio to be less risky of an investment, and therefore will be more willing to lend to you.
How to calculate your DTI
A debt-to-income ratio equals all of your monthly debt payments divided by your gross monthly income.
To calculate your DTI, add up all of your recurring monthly debts–such as student loan payments, credit card payments, and car payments. Use the minimum payment amount for each debt. Then, divide that number by your gross monthly income. Multiply that number by 100 to get a percentage.
For example, if you pay $1,200 a month for your mortgage and another $250 a month for an auto loan and $500 a month for the rest of your debts, your monthly debt payments are $1,950. If your gross monthly income is $5,000, then your DTI ratio is 39%.
Also see: How do student loans affect credit?
What is a good debt-to-income ratio?
A good DTI is one that is low. This demonstrates a good balance between your debt and income. On the other hand, a high DTI ratio shows that you have too much debt for your income. Lenders view this as a sign that you may not be able to repay your debts.
Wells Fargo breaks down their debt-to-income ratio standards:
- 35% or less: Good
Your debt is manageable compared to your income. People with a DTI of 35% or lower likely have money left over for saving or spending.
- 36% – 49%: Room for improvement
Debt is being managed, but you may want to lower your DTI to account for any unforeseen expenses. Lenders may request more information about your finances before determining your eligibility for a new loan or line of credit.
- 50% or more: Not good
Debt accounts for more than half of your monthly income. Action should be taken to lower your DTI. Someone with a DTI of more than 50% likely has little to no funds left over to spend or save, and it would be difficult to handle unforeseen expenses.
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How to improve your DTI
If you have a high DTI, or just want to lower it, there are two ways to do so. Either reduce your monthly recurring debt or increase your gross monthly income.
To reduce your monthly debt, pay off credit cards or pay down other loans that you’re able to. Or, consider a consolidation or refinanced loan that could lower your monthly payments, especially for student loans. To increase your income, consider asking for a raise or taking on a side job. Overall, if your DTI is high, it’s important to pay off your debts before taking on more.
Also see: Do student loans affect buying a house?