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Your credit score isn’t the only thing you need to worry about when applying for a new credit card or loan. Having a good debt-to-income ratio (DTI) is also key to qualifying, and understanding it can set you on the path to getting a better interest rate or loan terms.
A debt-to-income ratio is the amount of debt repayments you make each month divided by your income. Lenders use your DTI as one way to make sure you’re in a position to afford to repay a new loan.
Typically, underwriters figure out your DTI themselves. But knowing your ratio before you apply can help you tell if it’s a good time to apply for a loan or credit card. If your score is too high, you might want to consider paying off some debt first to avoid high rates or getting rejected.
The lower the better, naturally. More specifically, a DTI of 35% or below is generally considered good – though you might not qualify for a loan with a DTI that’s above 43%.
Why 43%? Lenders came up with this number as a result mortgage-risk studies that analyzed the type of borrowers who are most likely to have trouble making payments — and therefore default on their loans.
Your DTI is a factor lenders consider when determining the rates and terms of your loan. In general, you’re more likely to get a good rate with a lower DTI.
To calculate your DTI, you first need to know what counts as debt and what counts as income.
Debt includes your regular monthly repayments on personal loans, student loans, car loans, mortgages or any other type of loan. Your monthly minimum credit card payments also count as debt, as do unpaid bills sent to collection agencies.
Things like rent, utility bills, cable bills (or, let’s be real, Netflix subscription fees) aren’t included in your DTI. Car insurance, health insurance and other types of insurance premiums also don’t count as debt.
You might think that monthly bills besides credit card and loan payments should count. But here’s why they don’t: With these bills, you’re paying for a service, typically one that’s consistent.
The income DTI refers to is your gross monthly income — that is, your income before taxes or deductions are subtracted. Income includes your salary, but it’s not limited to just what you bring in each month.
Tips or bonuses, pensions, retirement account distributions, Social Security benefits, alimony and child support all count as income too. Think of income as any kind of money that’s coming in that you don’t have to repay.
In a word: Loans. Borrowed money doesn’t count as income because it’s money you have to pay back — in other words, it’s actually debt.
You also can’t include income that you don’t have reasonable access to when calculating your DTI. Say you’re a student and still count as a dependent when your parents file for taxes. Even if you get most of your money from your parents, you can’t count their income as yours when applying for a credit card or student loan.
If your lender doesn’t want to know how much you owe or earn, it’s just one sign that it might be predatory.
If you come across a lender that markets itself in this way, make sure it’s legit before signing on. Read online reviews, check out its accreditations and confirm that it’s not on lists of lenders to avoid, like those compiled by the Consumer Financial Protection Bureau and state consumer protection agencies. Take a look at its ratings with the Better Business Bureau and take heed of any complaints.
Americans’ debt burden has been high for a while now: A recent Federal Reserve report estimates the average American household carries $137,063 in debt. You’re probably not alone if your debt-to-income ratio is above or close to the 43% cutoff.
Here are some ways you can tamp down your DTI.
If you don’t need that loan right away, consider holding off on reapplying until you’ve taken steps to improve your DTI. Showing that you can repay your loan is one of the most important factors to a reputable lender.
If it’s an emergency, consider applying for a short-term loan, which often comes with more lenient eligibility requirements. But there’s no guarantee you’ll be approved for that either. Even if you are, you could end up with astronomical interest rates that can send you into a debt spiral if you’re unable to make a payment.
Your debt-to-income ratio is an important determining factor in getting a loan, right up there with your credit score. While many lenders calculate your DTI for you, knowing yours can help you figure out the type of loan you can qualify for.
If your DTI is over 43%, consider taking steps to lower it before applying for new credit.
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