Why Your Debt-to-Income Ratio Is So Important
Your debt-to-income ratio is an important indicator of how well you manage your money and your financial obligations. Here's why lenders use it when making decisions.
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When you apply for credit, your FICO® Score is an important factor that lenders consider, but it's only one thing they look at during the underwriting process. Your debt-to-income ratio is also an important indicator of how well you manage your current debt obligations and your ability to take on another one.
Here's what you need to know about your debt-to-income and how it plays a role when you apply for a loan.
What Is the Debt-to-Income Ratio?
Your debt-to-income ratio, or DTI for short, shows lenders how much of your current income goes toward paying your debt obligations. To calculate it, you'll add up all of your monthly debt payments and divide the sum by your gross monthly income.
Your debt payments include minimum payments on your credit cards, loan payments and even payments on loans for which you're a co-signer — even if you're not making any of the payments yourself. It doesn't include things like utility bills and other recurring charges that aren't debts.
For example, let's say you earn $5,000 monthly before taxes and have the following debt payments:
- Auto loan: $250
- Student loans: $340
- Personal loan: $200
- Credit card 1: $90
- Credit card 2: $75
Combined, your monthly payments equal $955. You'll then divide that figure by $5,000, giving you a DTI of roughly 19%. As you take on new loans, your DTI will increase unless you pay off other loans or credit cards.
On the flip side, your DTI will decrease if your income increases or if you pay off a debt account and no longer have that monthly payment.
Why Lenders Care About Your Debt-to-Income Ratio
Your FICO® Score is important in lending decisions because it's an indicator of how well you are likely to pay your credit obligations as agreed. But your DTI is important because it helps creditors better understand your capacity to take on new debt and repay it as agreed.
If your DTI is relatively high, adding another loan or credit card could make it more challenging for you to keep up with your monthly payments. As a result, a high DTI could result in a higher interest rate to help make up for the added risk, or it could cause your application to be denied altogether.
Your DTI is especially important when you're applying for a mortgage loan. Lenders typically look at two different types of DTI: your front-end DTI and your back-end DTI:
Front-end DTI: This ratio considers only your housing costs, such as your loan payment, mortgage insurance, homeowners insurance, homeowners association fees and property taxes. Mortgage lenders typically like to see a front-end DTI of 28% or less.
Back-end DTI: This includes all of your monthly debt payments plus your housing costs. Your best bet if you want a lower interest rate is to have a back-end DTI of 36% or less, but qualified mortgages are available for borrowers with DTIs as high as 43%, and the maximum allowable DTI is generally 50%.
With other loans, lenders may also allow DTIs as high as 50%. But remember, the higher your DTI, the harder it will be for you to get approved for a loan, especially if your overall creditworthiness isn't in stellar shape. If you do get approved, you may be facing a higher interest rate, which could cost you hundreds, thousands or even tens of thousands of dollars over the life of the loan depending on the loan type.
How Does Your Debt-to-Income Ratio Affect Your FICO® Score?
Your DTI doesn't directly impact your FICO® Score because your income is not considered when calculating your score.
However, how much you owe is an influential factor in your FICO® Score, so if your DTI is high because you have a lot of debts, that debt could have a negative impact on your score.
Steps You Can Take to Reduce Your Debt-to-Income Ratio
If you're hoping to apply for a mortgage loan or another type of loan in the near future, calculate your DTI to see where you stand. If it's relatively high compared to what lenders are looking for, you may want to take some time to reduce it before you submit your application. Here are a few steps you can take:
Pay off low-balance loans: If you have one or more loans with a relatively low balance, consider making extra payments toward those debts to eliminate the monthly payments from your credit reports.
Extend your repayment on student loans: If you have student loans, consolidating them with a longer repayment term or getting on an income-driven repayment plan could reduce your monthly payment enough to help you achieve your goal. Just keep in mind that extending your repayment schedule typically results in higher total interest charges
Postpone large purchases: If you're thinking about using a loan or a credit card to make a significant purchase, consider holding off so you don't have that extra payment to worry about.
Increase your income: Look for opportunities to increase your income, such as asking for a raise, working overtime or taking on a second job. Keep in mind, though, that if you start a side hustle, you typically need a couple of years' worth of self-employment income to be able to count it on a credit application.
As you take these and other steps to lower your DTI so you can be in a better position to secure affordable financing when you need it.