Debt-to-income ratio definition & how it affects loan offers
What is a debt-to-income ratio in connection to a loan application?
Your debt-to-income ratio is all your monthly debt payments divided by your gross monthly income. Your gross monthly income is generally the amount of money you have earned before your taxes and other deductions are taken out. This number is one way lenders measure your ability to manage the payments you make every month and repay the money you borrowed.
For example, let’s say your monthly income is $3,000 and your total monthly debts (loans) are $500. That would give you a debt-to-income ratio of 16.7%.
In general, the lower your debt-to-income ratio, the better when you apply for a loan. A low DTI demonstrates you have a good balance between earning and spending. A higher DTI means that you may have difficulties making your payments on time or may be unable to afford new credit lines in the future.
How is a debt-to-income ratio calculated?
There are two types of DTI ratios: front-end and back-end. A front-end ratio is your monthly housing costs, including mortgage payments, property taxes, and insurance, divided by your gross monthly income. This is also known as your “housing ratio.” A back-end ratio includes all of your monthly debt obligations, such as credit card payments, student loans, auto loans, etc., divided by your gross monthly income.
What is a good debt-to-income ratio when applying for a loan?
The general rule is your debt-to-income ratio should be 36% or less, but lenders may consider ratios up to 100%. If your debt-to-income ratio is too high, you may have a hard time qualifying for a loan or you may have to pay a higher interest rate.
A debt-to-income ratio of 20% or less is considered ideal. A ratio of 36% or less is still considered good. Ratios above 43% may make it difficult to get approved for a loan.
How can I improve my debt-to-income ratio and get better loan offers?
DTI is used by lenders to determine how much you can borrow and it plays an important role in getting a mortgage approval. A high DTI indicates you may have difficulty making your monthly debt payments and it may be more difficult to get approved for a loan.
There are a few ways to improve your DTI:
- Pay off debts: This will lower the amount of monthly debt payments you have and will improve your DTI.
- Increase income: This will increase the amount of money you have available to make monthly debt payments and will improve your DTI.
- Refinance debts: This can lower the interest rate on your debts, which will lower the amount of monthly debt payments you have and improve your DTI.
What are the consequences of a high debt-to-income ratio when applying for a loan?
There are a number of potential consequences of having a high debt-to-income ratio, including the following:
- You may have difficulty qualifying for a loan.
- You may have to pay a higher interest rate. If you do qualify for a loan, you may end up paying a higher interest rate because lenders see you as a greater risk.
- You could end up in financial trouble if you can’t make your payments.
If you can’t make your monthly loan payments, you could end up in serious financial trouble, including bankruptcy. This is why it’s so important to make sure you can afford the payments before you take out the loan.
Bryan Robinson
Writer and editor
Bryan Robinson is a finance writer with expertise in lending and their interest rates, fees, contracts and more.
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