When applying for loans, we often worry most about our credit scores. Many people don’t realize that there’s another factor that lenders consider: your debt-to-income (DTI) ratio.
But what is the debt-to-income ratio, and why does it matter?
In this post, we’ll cover everything you need to know about the debt-to-income ratio. We’ll teach you what a DTI ratio is, how to calculate your debt-to-income ratio, what a good DTI ratio looks like, how to lower your DTI, and more.
What Is The Debt-To-Income Ratio?
The debt-to income (DTI) ratio is a financial tool used to measure the relationship between a person’s debt and income. The DTI ratio is calculated by dividing recurring monthly debt payments by gross monthly income.
When applying for a loan, lenders look at your DTI to see if you can afford regular monthly payments based on your income and to determine how much of a risk you are.
The debt-to-income ratio is primarily used when applying for personal mortgages (though some other personal loans depend on your DTI as well). For small businesses applying for loans, greater value is placed on your debt service coverage ratio (DSCR).
However, the debt-to-income ratio is still important for sole proprietors and freelancers in need of financing. Sole proprietors aren’t legally considered separate business entities and therefore don’t have a DSCR — this means lenders will look at your debt-to-income ratio when considering your loan application.
Why The Debt-To-Income Ratio Is Important
Your debt-to-income ratio is important for two reasons:
- It indicates how financially healthy you are.
- It plays a large factor in how likely you are to qualify for a loan.
Before applying for a loan, it’s important to consider whether you can actually afford one. By calculating your DTI ratio, you can analyze how much existing debt you have and whether or not it’s financially wise to take on more debt considering your monthly income. In addition, figuring out your DTI ratio will help you determineÂ how much debt you can realistically take on.
If you calculate your DTI and see that there’s room to wisely take on more debt to purchase property or expand your business, awesome. If you have too much debt or too little income, taking on more debt might not be the right option — at least not until you lower your DTI. Knowing your DTI ratioÂ before you even start talking to potential lenders will save you a whole lot of trouble.
For lenders, your DTI is important as well. Whereas a credit score shows how likely you are to make payments, your debt-to-income ratio shows lenders that you can afford to make monthly payments on a potential loan.
If your debt-to-income ratio is too high, lenders may reject your loan application because you’re too high of a risk. If your DTI is low, lenders are more likely to approve your loan because they trust that you will be able to pay back your debt.
Here are some of the key benefits of a low debt-to-income ratio:
- More likely to qualify for a loan
- More likely to receive an offer with better loan terms
- Increases your chances for lower interest rates and higher loan amounts
- Can potentially afford to take out multiple loans
- Less stress and worry about if you can make your monthly payments
For small businesses, your personal DTI also has a role to play. While most predominantly look at a small business’s debt service coverage ratio (DSCR), manyÂ lenders also evaluate a business owner’s DTI, both to affirm your trustworthiness and to ensure that you canÂ personally guarantee your business loan if no other collateral is provided.
The bottom line? The DTI is incredibly important for individuals and business owners alike.
How To Calculate Your Debt-To-Income Ratio
To calculate your debt-to-income ratio, you’ll need to divide your total recurring monthly debt payments by your gross monthly income. The DTI is always expressed as a percentage. This is the DTI ratio formula:
Total Monthly Debt / Gross Monthly Income = Debt-To-Income Ratio
But how do you determine your total monthly debt and gross monthly income?
Total Monthly Debt
Your total monthly debt includes all of yourÂ recurring monthly debt payments, such as mortgage payments, car payments, student loans, credit card balances, etc.
To tally your total monthly debt, add up all of theÂ minimum payments on your monthly debt. For example, if you pay $100/mo on your credit card, but onlyÂ have to pay a minimum of $25/mo, use $25 when adding your total recurring monthly debt.
Gross Monthly Income
Your gross monthly income is your total monthly incomeÂ before taxes. You can calculate this a few ways. If you get paid on salary, use this formula to determine your gross income per month.
Gross Monthly Income = Annual Salary / 12
If you get paid hourly, first multiply your hourly wage by the average number of hours you work each week. Then multiply that number by 52 to get your annual gross income. Divide that number by 12 to get your monthly gross income.
Be sure to include all forms of monthly income in your gross monthly income calculation.
Now that you know how to figure your total monthly debt and your gross monthly income, let’s do an example using the DTI formula from earlier:
Total Monthly Debt / Gross Monthly Income = Debt-To-Income Ratio
Let’s say you’re trying to use your DTI to see if you qualify for a mortgage. You pay $300/mo for your car and $200 on student loans for a total monthly debt of $500.Â Your monthly gross income is $3,500/mo.
500 / 3,500 = Debt-To-Income Ratio
500 / 3,500 = 0.142857
When you divide 500 by 3,500, you’re left with 0.142857. To turn this decimal into a percentage, simply move the decimal point two places to the right and round to the nearest tenth. This gives you a current debt-to-income ratio of 14%.
Now, we’ve successfully figured a DTI ratio! Try putting your own financial information into the formula.
What Is A Good Debt-To-Income Ratio?
You now know how to calculate your DTI ratio, but how do you know what the DTI ratio means? Is your DTI good or bad?
When it comes to DTI ratios, the lower the better. A low DTI indicates that you can comfortably take on a loan and make your monthly payments, which means you are more likely to be approved by lenders.
A higher DTI indicates that you may struggle to cover monthly payments, making it more difficult to qualify for loans.
While accepted debt-to-income ratios vary by lender, generally a DTI of 36% or lower is considered a good debt-to-income ratio. Many lenders will finance (up to) a 43% DTI. If your DTI is higher than 43%, you may have a hard time getting approved for a loan. You should consider lowering your DTI before applying.
Again, this will vary by lender. According to Lending Tree:
While the mortgage industry has specific guidelines that most lenders will adhere to, other types of loans are less regulated and largely leave the decision in the hands of the lender.
Mortgage lenders often stick to the 28/36 rule (they’ll lend you a loan so long as your DTI is below 36% with no more than 28% going toward the mortgage). Other types of loans may not be so dependant on these numbers. Some lenders may grant funding to people with a DTI of 43% or higher, albeit with less favorable terms and rates. It all depends on the lender and the type of loan you’re applying for.
For this reason, it’s important to research each lender’s specific qualifications and striveÂ to keep your DTI as low as possible. This will both increase the likelihood of getting approved for a loan and give you peace of mind about your financial health.
Using DTI To Determine If You Can Afford A Loan
Not only does your DTI tell you if you can afford a loan, it also helps determine how big of a loan you should take out.
For example, let’s return to our example from earlier. Remember, you were trying to qualify for a mortgage loan. We calculated your current debt-to-income ratio at 14%.
If you want to keep a good debt-to-income ratio, you don’t want your total DTI ratio to exceed 36%. That means a potential mortgage can take up 22% of our total debt-to-income ratio (36 – 14 = 22).
We can now use this number to determine the size of the mortgage loan payment you could afford each month. Simply multiply your total gross income by 22%. (To convert the percentage into a decimal, move the decimal point two spaces to the left.)
3,500 x .22 = 770
If you want to stick to a 36% DTI, you can afford to pay $770/mo on your mortgage while still making your other monthly loan payments and covering everyday expenses.
If you approach a potential lender knowing exactly how much you can afford to pay each month, you can avoid being heckled into borrowing more than you can afford.
How To Lower Your Debt-To-Income Ratio
By now, the importance of a low debt-to-income ratio has sunk in. The real question becomes: how can you lower your DTI? There are several ways to lower your debt-to-income ratio:
- Increase your monthly income
- Pay off some of your debt
- Decrease your borrowing amount
Increasing your income is a good way to lower your debt-to-income ratio, though this option doesn’t always seem achievable. Consider asking for a raise or starting a side hustle to bring in more additional income.
Decreasing your debt is another viable option. Carefully evaluate your budget. Cut unnecessary expenses and allocate that money to paying down your debt instead. You can pay off your debt quickly using various methods like the debt snowball method or the debt avalanche method. Depending on your financial situation, consolidating your debt might also be a good option.
If you’re applying for a mortgage loan, you can also make a larger down payment, which will lower your monthly payments and, in effect, lower your DTI.
The debt-to-income ratio is important for individuals, sole proprietors, and small businesses alike. Your DTI ratio is a big decision-maker for lenders. But more than that, calculating your DTI can help you analyze your financial health, determine whether taking on more debt is right for you, and help you pinpoint how much you can afford to borrow.
As always, we recommend carefully evaluating your financial situation before seeking financing. Evaluate your DTI, consider where you want to be financially, and know exactly how you would use a loan ahead of time. Once you’ve done this, evaluate all of your lending options before making a decision, so that you can get the best terms and rates. Merchant Maverick’s small business loan calculators can be a great resource when you start looking at individual loan products.
Looking for good lending options? Our small business loan reviews cover both online lenders and major banks. We’ve also reviewed lines of credit and MCAs, though you should think long and hard before taking out a merchant cash advance. If you’re just starting out, you might want to consider taking out a personal loan and using it for your business.
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