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Debt-to-Income Ratio: What Is It, Why It’s Important

Debt to Income Ratio

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updated: July 4, 2024

Lenders look at a number of factors when deciding if you’re eligible for financing. They consider your income, credit score and history, assets, and more.

Then they use your financial information to determine if you can afford a new loan or credit line. The formula they use to make their determination is called the debt-to-income (DTI) ratio. This ratio is expressed as a percentage and offers insight into whether a new monthly payment will fit into your budget or stretch you financially.

Here’s what to know about DTI ratios, how they’re calculated, and how to lower yours if a prospective lender determines it’s too high.

How is the debt-to-income ratio calculated?

Lenders calculate your DTI by taking your total monthly debt payments and dividing them by your gross monthly income—your earnings before taxes and other payroll deductions. The formula for DTI ratios is as follows:

Total monthly debt payments / Monthly gross income = DTI ratio

Real world example of the DTI ratio

Let’s say borrower A is interested in buying a home. They’re currently shopping around for properties and comparing mortgage rates. Borrower A earns $7,000 a month, and their monthly debt payments are as follows:

  • Credit cards: $100
  • Rent: $1,700
  • Student loans: $300

In this case, borrower A makes $2,100 worth of payments each month. If we divide that figure by $7,000, we get a DTI ratio of 30%.

Debt-to-income ratio limitations

While your DTI can be a helpful figure for lenders, it’s not the only thing they review when you apply for a loan. Your credit score and history will also be significant factors in determining your eligibility.

Besides that, your DTI only looks at your total monthly debt payments, not interest rates. So a low-rate student loan is counted the same as a high-rate credit card. It’s possible that consolidating your high-interest-rate debt could reduce your monthly payments and thus your DTI. But if you’re getting a mortgage very soon, taking out a debt consolidation loan could impact your financial profile and isn’t necessarily advisable.

What is an ideal debt-to-income ratio?

A good DTI is generally at or below 36% if you’re applying for a mortgage; an ideal one could be even lower than that. In theory, the lower your DTI, the less of a lending risk you become.

Of course, lenders look at other factors besides your DTI when evaluating your loan applications. So someone with a DTI of 25% and poor credit may be less likely to get approved for financing than someone with a DTI of 35% and good credit.

Which factors make up a DTI ratio?

Several factors make up your DTI ratio, including the following:

  • Gross monthly income.
  • Mortgage or rent payments.
  • Credit card minimum payments.
  • Alimony or child support payments.
  • Monthly loan payments (student, car, personal loans, etc.).

How lenders view your DTI ratio

Your DTI ratio offers lenders insight into whether you can afford your monthly payments. Lenders can have different DTI requirements. Generally, you’ll need a DTI ratio at or below 36% to be approved for a conventional mortgage. That said, some lenders may be willing to accept a DTI of up to 45% if you havet excellent credit or significant assets.

DTI requirements for Federal Housing Administration (FHA) loans and personal loans are often more flexible. If you’re concerned your DTI might be too high, ask your lender about its criteria for borrowers.

Does my debt-to-income ratio impact my credit?

Your debt-to-income ratio won’t have a direct impact on your credit score. But the amount of debt you carry does affect your credit.

Under the FICO credit scoring model, which is used by many lenders to determine borrower eligibility, the amounts you owe account for 30% of your credit score. Your total credit utilization and your balances also factor into your VantageScore, another popular model lenders rely on.

So if you have significant debt, and are using a large portion of your available credit, it could hurt your credit score and your ability to get a loan. This can serve as a signal to lenders that you’re financially stretched.

How to lower your debt-to-income ratio

If your high DTI ratio is serving as a barrier to qualifying for a loan, you can take some steps to lower it:

  • Increase your income: Taking on a part-time job or a side gig could help increase your earnings and lower your DTI.
  • Put more money toward existing debt: Making larger monthly payments toward existing debt, especially revolving debt such as credit cards, could also positively affect your DTI.
  • Avoid taking on new debt: Since taking on new debt can be detrimental to your DTI, you should avoid doing so if your goal is to lower it.

TIME Stamp: Lenders prefer a low DTI

Your DTI gives lenders some insight into the percentage of your income that goes toward your existing debt. In general, a lower DTI is considered better when you’re applying for a loan.

But lenders don’t consider DTI in a vacuum. They’ll look at other factors as well to determine your lending risk. If you plan to apply for a loan soon, focusing on reducing your DTI and improving your credit score will increase your likelihood of being approved.

Frequently asked questions (FAQs)

Is a 50% debt-to-income ratio good?

Most lenders would consider a 50% debt-to-income ratio to be high. You’d likely need to lower your DTI to get approved for a loan or credit line.

What does a 30% debt-to-income ratio mean?

A 30% debt-to-income ratio is decent by many lenders' standards. It means 30% of your monthly gross income goes toward your existing debt payments.

Is 20% a good debt ratio?

A 20% DTI is a good ratio by many lenders’ standards. That said, lenders will also evaluate other factors, including your credit score and history, when deciding if you’re approved for financing.

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