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If you thought that your credit score was the only financial number you had to keep in check, think again!
A few years ago, when my friend Greg applied for a mortgage, he wasn’t prepared for what came next. His application was denied because they said something called his “debt-to-income” ratio was too high.
This completely caught Greg off guard because he had always been very diligent about making his payments on time. But as he soon found out, that wasn’t enough to convince the bank that he was a good candidate.
In this post, we’ll talk about what your debt-to-income ratio is and why it’s so important for getting a loan. We’ll also explore some ways to raise yours so that you’ll be in great financial shape for when you make your next big purchase in life.
What Is a Debt-to-Income Ratio?
Your debt-to-income (DTI) is a ratio of how much of your earnings goes towards your debts. It’s calculated by taking your monthly debt payments (which we’ll explain in more detail below) and dividing them by your monthly gross income (i.e. before taxes).
For instance, in my buddy Greg’s case, his annual salary was about $60,000 at that time. That means his monthly gross income before taxes and retirement contributions was $5,000.
On the expense side of things, Greg was spending about $1,000 per month on bills like student loans, two car payments, and credit cards for both him and his wife. On top of that, he was applying for a house that would cost around $1,500 per month. Altogether, that would put his total monthly debt at $2,500.
Therefore, if we divide Greg's monthly expenses by his income, we can calculate his DTI to be $2,500 / $5,000 = 50%. (If you need any help calculating your debt-to-income ratio, then you can use a free online calculator like this one.)
Why DTI Matters to Lenders and Creditors
Think about what would happen if I asked to borrow money from you. As your friend, you might already know that I’m an upstanding guy who pays all of his bills on time.
But as a lender, you have to protect your own interests and ensure that you’re going to eventually get paid back. In order to reduce your risk as much as possible, you’d probably be very interested in my capacity to pay you back, and rightfully so.
This is exactly the same reason that lenders and creditors are interested in your DTI ratio. They want to know that you’re someone who is going to not only pay them back on time but also have the financial means to continue doing so throughout the life of the loan.
That’s why your credit score isn’t enough. Sure, it might demonstrate financial responsibility. But remember that your FICO score doesn’t take into account your income.
Hence, to understand your financial means better, they’ll require more information about your income and other expenses. They need to know that you’ll have the means to pay back the entire loan and that other debts won’t take priority.
Debt-to-income is the way that they can judge this. Through accessing how much money you earn and what other payments you’re already committed to paying, they’ll be able to access if you’re a worthwhile candidate.
One of the most common places you’ll see DTI used is when you apply for a mortgage. And for good reason – Most conventional mortgages allow you to take 30 years to repay your loan.
30 years is a pretty substantial commitment from the lender. So as you might guess, they’re going to be pretty critical of your financial means and only work with those candidates who meet their requirements.
To qualify for most mortgages, you have to pass what’s known as the 28/36 rule. This is a simple check of your financial situation consisting of two parts:
- The front-end ratio: No more than 28 percent of your monthly gross income should be spent on household expenses (principal, interest, property taxes, and insurance).
- The back-end ratio: No more than 36 percent of your monthly gross income should be spent on recurring debt payments. This is your debt-to-income ratio.
There are some situations where lenders will still agree to provide you a mortgage even if your debt-to-income is as high as 43 percent. For instance, you may qualify for an FHA loan, but it will also mean taking a higher interest rate (and higher payment) than a conventional mortgage.
Studies have shown evidence that borrowers with a DTI any higher than 43 percent are significantly more likely to have difficulties making their payments as time goes on. As the metric suggests, you may want to wait to buy a home or search for other options that are a better match for your price range.
Though your debt-to-income ratio does not directly affect your credit score, it can inhibit your ability to qualify for certain credit cards.
When I applied for my last credit card, two financial questions they asked me were:
- My annual household income
- My monthly mortgage or rent payment
(Although the credit card company just asked me to input these numbers on the application, keep in mind that for other loans, you’d be required to submit evidence such as recent paycheck stubs, bank statements, mortgage statements, etc.)
Similar to a mortgage, the creditors were trying to determine if I would be a reliable cardholder and able to make my payments. Since they also run a credit check as part of the application process, that means they can also look through my credit history and see how many other recurring debts I have on file.
Credit limits are also calculated using this information. The better your credit score and the lower your debt-to-income ratio, the higher the credit limit you’ll be granted.
Which Expenses Affect My Debt-to-Income Ratio?
Several expenses get taken into consideration when someone calculates your debt-to-income ratio. The major ones include:
- What you’re paying currently on your house or for rent. Keep in mind that if you’re applying for a new mortgage, then they’ll want to take your new principal and interest payment into consideration.
- The minimum monthly payment that’s required by your credit cards
- Student loan payments
- Auto loan payments
- Personal loan payments
- Alimony or child support payments
- Any other recurring monthly payments that would appear on your credit report
When I was in my 20s, my first mortgage was approved with no problems. I like to believe this occurred because I was young and didn’t have many of these types of expenses yet, and so my DTI was very low.
In the case of my friend Greg, he was in his 30s, newly remarried, and had accumulated a lot of expenses. While this is a perfectly natural part of life, it, unfortunately, caused his debt-to-income to become too great for lenders to consider him.
This is why it’s important to always be mindful of how many loans you have and how they might affect your other financial goals.
What Doesn't Count Towards DTI?
Here’s some good news: Not all of your expenses will be considered in a debt-to-income calculation. Here are a few that usually fly under the radar:
- Payments that do not go on your credit report. These might be common expenses like your utilities, insurance, medical bills, and subscription services. As long as they are paid by check or automatic draft from your bank account (and not put on your credit card), lenders will have no way of knowing these expenses exist.
- Cash transactions. If you’re in the habit of using cash to pay for certain expenses (like buying lunch or having someone mow your lawn), then these transactions will also be undetectable to lenders.
- Retirement plan contributions. Because the money you save to your 401k and IRA takes away from your paycheck, you might think it would be considered a recurring expense. However, DTI only looks at gross income – the money you’re paid before taxes and retirement plan contributions are taken out. Therefore, lenders don’t know or care how much you’re putting in your 401k and IRA.
How to Lower Your Debt to Income
When my buddy’s mortgage application was rejected based on his debt-to-income ratio being too high, we sat together at lunch and brainstormed a few ideas on how he could get it reduced. Here are a few tips you can try yourself if you’re stuck in the same situation.
Payoff Your Debts
The first thing you can do is to pay off your debts as quickly as possible. This will be helpful because the less recurring debt that shows up on your credit report, the lower your debt-to-income ratio will be.
For instance, if you’ve got a $400 per month auto loan, then you could put extra money towards the principal to pay it down faster. Other popular strategies include the debt snowball and debt avalanche.
Don’t Use Your Credit Cards as Much
The more you use your credit cards, the higher your minimum monthly payment will be. If you don’t pay your balance in full every month then the interest that will accumulate can also affect your monthly required minimum.
Therefore, you may want to consider using your credit cards as little as possible so that your minimum monthly payment will go down. Pay for things using cash or check whenever possible.
Don’t Take on Any New Debts
If you’re planning on applying for a major loan like a mortgage, then it would be a good idea not to also apply for any other big loans at the same time.
For example, don’t get an auto loan six months before you plan to also apply for a mortgage. We want your debt to appear as minimal as possible, so hold off on these other purchases for as long as possible.
Refinance or Consolidate Your Debts
Since the monthly payment is what’s taken into consideration, you may find it helpful to refinance or restructure your current loans. For example, if you’ve got a student loan with a 10-year term, you might want to look into options for extending this to 15 or even 20 years.
Similarly, if you’ve got a lot of credit card debt, a consolidation loan might help. It could have a longer term or better interest rate, and these factors could reduce the size of the overall monthly payment.
If you’re thinking about using this strategy, be sure to do it at least 12 months in advance of when you want to apply for your loan. This will give you the best chances of having a clean starting point for your DTI calculation by the time your lender sees it.
Get a Higher Paying Job
On the income side of things, if you’ve been stuck at the same wage or salary for a while now, perhaps it's time to seek a change. You could speak to your manager about potential possibilities for promotion or taking on another type of position.
If that doesn’t work, you could always shine up your resume and apply to work for the competition. I’ve known dozens of coworkers who have done this; some going to work for other companies making as much as 25% more than they were being paid.
Find a Side Hustle
If you’re feeling entrepreneurial, then another tactic you could try is to take up a side hustle. Your side hustle could be literally anything such as delivering groceries, driving people around, or freelance writing.
The great thing about side hustles is that you can do them on your own time and according to your own terms. Plus, if you get good at doing them, then you can also command some pretty lucrative rates. For instance, I’ve been paid as much as $65 per hour to work as a freelance writer.
Lower How Much You’re Asking For
Since the loan you’re applying for is considered part of the debt-to-income calculation, you may have to reduce how much you wish to receive.
For instance, when it comes to mortgages, if you’d like to buy a $200,000 home but your DTI is too high, then one way to reduce your loan amount would be to bring a bigger down payment to the table (such as borrowing from your savings or IRA)
If all else fails, then you may also have to accept the reality that the houses you’re applying for may be out of your price range.
Though this may be difficult at first, if you keep at for long enough, you’ll be sure to eventually find something that checks all of your boxes but is better suited for your budget.
The Bottom Line
Your debt-to-income is how lenders and creditors determine if you're a qualified candidate for their services. By comparing the ratio of your debts against your income, they can access if you have the financial capacity to make your payments in full and hopefully not run into any trouble continuing to do so.
To qualify for a major loan like a mortgage, your DTI generally has to be less than 36 percent. This will include any recurring payments such as auto loans, credit card minimum payments, student loans, and the payment amount of the loan that you’re applying for.
If you need to lower your debt-to-income ratio, then you'll want to focus on paying off your debts and lowering your payments as much as possible. You can also raise your income by seeking a promotion, looking for a new job, or taking on side hustles. By taking these actions, you'll not only improve your DTI ratio, but you’ll also make a positive impact on your overall financial situation.
As for my buddy Greg, he did eventually get approved for a mortgage. But it wasn’t until his wife took a higher paying job and the two of them spent months eliminating some of their other debts.
It certainly wasn’t easy, but in the end they got the house they wanted and, more importantly, one that they could afford.
- First-Time Homebuyer’s Guide to Pre-Approved Mortgage Loans
- Understanding Homeowners Insurance
- Things to Consider When Buying a House With Bad Credit