You might have heard the term debt-to-income ratio and have wondered what exactly it is. After all, you probably didn’t learn about it in school, which means it’s been up to you to educate yourself on the topic. And who has time for that?
Actually, as complicated as it might sound, debt-to-income ratio is a pretty simple concept to grasp. It’s the total amount of your debt payments you make each month divided by your monthly income before taxes and withholdings.
But why should you care what your debt-to-income ratio is? Does it matter? In a word, yes.
“Knowing your debt-to-income ratio can give you a snapshot of your finances,” said Leslie Tayne, a debt relief attorney and author of Life & Debt: A Fresh Approach to Achieving Financial Wellness. “It can also provide you with a perspective on where your debt is and how that relates to your income. From there, you can create goals to make adjustments to minimize debt and increase income.”
Calculating your debt-to-income ratio
Start by adding up all of the monthly debt payments you make. Say you owe $1,000 for your mortgage, $500 for student loans, $400 for a car loan and $100 for credit cards. That brings your monthly total to $2,000.
Now, let’s say your monthly wages before taxes and withholdings are $4,500. If you divide 2,000 (your total debt payments) by 4,500 (your monthly income), you get 0.44. Multiply that by 100 to change the decimal to a percent, and the result is a 44% debt-to-income ratio. That means 44% of your monthly income goes toward debt payments.
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Why your debt-to-income ratio is important?
It can be eye-opening to see how much of your monthly income goes toward debt. Knowing this might motivate you to pay down your debt faster.
However, when your debt-to-income ratio really matters is when you apply for a loan, Tayne said. Lenders – particularly mortgage lenders – look at this ratio to determine how much of a credit risk you are.
“The better your debt-to-income ratio, generally the lower your interest rate will be because lenders will feel as though you will have the resources to make your payments,” Tayne said. And a high debt-to-income ratio signals to lenders that you might have a harder time paying back a loan because you’re already burdened by debt. As a result, they might charge you a higher interest rate or refuse to give you a loan.
How does a debt-to-income ratio impact your credit score?
Your debt-to-income ratio does not affect your credit score because your income is not included on your credit report, Tayne said. Only information in your credit report is used to determine your credit score.
However, your credit utilization ratio — how much you’ve borrowed against your allotted credit — does affect your credit score, Tayne said. If you are using a high percentage of your available credit, you will have a high credit utilization ratio – which can hurt your credit score.
What’s the ideal debt-to-income ratio?
Generally, 43% is considered the absolute highest debt-to-income ratio you can have to be considered for a mortgage, Tayne said. “However, the lower you can keep the ratio, the better,” she said. “Under 36% is generally considered ideal.”
Be aware that mortgage lenders will look at what is called your front-end debt-to-income ratio and back-end debt-to-income ratio. The front-end ratio is the percentage of your income that would go to cover housing costs, including your mortgage payment, homeowners insurance and property taxes.
Lenders typically want that ratio to be 28% or less. The back-end ratio includes other debt payments in addition to housing expenses. This is the 36% ratio to which Tayne was referring. The debt-to-income calculator at MortgageCalculator.org will figure both your front-end and back-end ratios.
How can you improve your debt-to-income ratio?
You don’t need to have no debt at all to qualify for a mortgage. “It’s generally understood that most people will have some debt,” Tayne said. “But keeping it in check proportionally to your income will make lenders feel more comfortable and therefore offer you better rates.”
To improve your ratio if it’s high, you can increase your income, reduce your debt or do both. There are several ways to boost your income: negotiate a raise, ask for more overtime work if you’re paid an hourly wage or get a second job to increase your income.
To reduce your debt, start by avoiding new debt. You might have to pull your credit cards out of your wallet to limit the temptation to spend. Then create a debt repayment plan. Some people prefer to tackle their smallest debt balance first, feel a sense of accomplishment by paying it off then move on to bigger balances. Another approach is to pay off the debt with the highest interest rate first to reduce the amount of interest you pay over time – which will reduce the total amount you owe.
You also can reduce the interest you have to pay – which will speed up debt repayment and save you money – by transferring your credit card balance to a card with a 0% or low-rate balance transfer offer. Or you could look for a personal loan with a lower rate than your credit card, use the loan to pay off your card then take advantage of the lower rate to pay off the loan quickly.
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Cameron Huddleston is the author of Mom and Dad, We Need to Talk: How to Have Essential Conversations With Your Parents About Their Finances. She also is an award-winning journalist who has been writing about personal finance for more than 17 years. You can learn more about her at CameronHuddleston.com.