How to calculate debt-to-income ratio

Key takeaways:

• Lenders look at debt-to-income (DTI) ratio when approving loans and lines of credit.
• This helps lenders understand a borrower's debt loan and if they can pay back money borrowed. 
• It's important to aim to keep your DTI as low as possible to increase your odds of getting approved for financing and to secure the best rates and terms.

Lenders commonly look at debt-to-income ratio when approving financial products like mortgages, personal loans, auto loans, and credit cards. A DTI helps lenders understand a prospective borrower's debt load and how it can impact their ability to repay a new loan.

Because DTI ratios are such a crucial part of the borrowing process and impact the approved loan amount or credit limit, rates and terms, it's important to have a firm understanding of what it is and how it's calculated. Read on to learn more:

What is debt-to-income ratio?

A debt-to-income ratio is the measurement of an individual’s total debt balance against your income. In other words, it's your monthly debt payments divided by your gross monthly income and expressed as a percentage.

What’s included in the debt-to-income ratio?

Here's the thing: Not all monthly debts are included in your DTI. When tallying up your total debts, you should only account for these expenses:

• Minimum credit card payments
• Student loan payments
• Alimony
• Child support payments
• Rent
• Mortgage payments
• Auto loans
• Personal loans
• Additional miscellaneous loans (like personal loans) or other debts

That said, it doesn't include utilities, groceries, or insurance premiums. These won't factor into your debt.

How to calculate DTI

To calculate your DTI, you can add the total monthly debts, then divide that number by your monthly gross income, which is your number before taxes and other deductions are accounted for.

For example, if an individual has a monthly debt total of $3,000 and gross income of $7,500, their DTI would be 40% (or 3,000/7,500).

What is a good DTI ratio?

While it depends, most lenders prefer a DTI of less than 36%. Mortgage payments or rent payments should account for less than 28% of the DTI.

A higher debt-to-income ratio is a smoke signal to lenders that you're managing larger amounts of debt. In turn, you could be financially stretched, and could result in falling behind on making on-time payments.

Calculating your DTI ratio as a couple

If you're partnered or want to apply for a loan as a co-borrower, when lenders approve couples for a mortgage, auto loan, or personal loan, they'll combine the income and debts of both parties when calculating DTI.

So what's the difference between calculating individual DTIs versus combined DTIs? It's actually the same formula. The only difference is that it includes two people's figures. So instead of using one person's monthly debt payments divided by their monthly gross income, you use the same formula, but by using two combined figures.

Here's the thing: the co-borrowers or couples may find that one person has a stronger DTI. If the DTI is too high, it may turn out that it's best that one person applies for the loan instead. That said, it's crucial to understand that if one partner or spouse applies for a loan, they may be qualified for a lower loan amount–depending on their income.

An example

Let's look at an example:

Tim and Lynn are a married couple applying for a personal loan. Together, they earn $9,000/month gross – before taxes.

Tim earns $5,000 a month, while Lynn earns $4,000 a month. Tim has debts that total $2,500, while Lynn owes $1,000. Tim's DTI is 50%, and Lynn’s DTI is only 25%. Their combined debts total $3,500. So if they apply for a personal loan together, their DTI would be around 39%, which is slightly above the preferred 36%.

As you can see, Lynn’s low DTI ratio lets her qualify for a personal loan – that is, as long as other factors, like her credit score, are also favorable. However, if Tim and Lynn apply for the loan together, their DTI would kick over the threshold, and it would be too high.

How to lower your debt-to-income ratio

By bumping down your DTI, you can help folks improve your financial appeal to lenders. It's true that different types of loans and lines of credit can have varying DTI requirements, and these can also vary by lender. That said, across the board the lower your DTI, the more favorable you'll be in the eyes of lenders.

Here's what you can do to decrease their debt balances and improve their DTI:

• Pay down balances. You can use debt strategies like the debt snowball method or debt avalanche method to tackle debt balances. Paying down debt helps improve your DTI, and it can also bolster your credit utilization ratios, which can also increase your credit score. That's because credit usage makes up 30% of a FICO^® Score. Because your credit history makes up 35% of your score, making on-time payments also can give credit scores a boost.
• Make a budget and track spending. Create a budget and stick to it. Budgeting gives you awareness of your cash flow. Track your monthly spending monthly to find unnecessary expenses to cut. The "extra money" can be put toward debt.
• Say no to new debt. Don’t apply for a new credit card or pile on any additional expenses that can further thrust DTI into the red zone. Remember: Taking on a new loan or credit account before applying for a mortgage or auto loan could potentially sabotage your chances of getting approved.
• Consider debt consolidation. High-interest loans – and credit cards – can make it hard to get financially ahead and pay down your balance.
  A debt consolidation personal loan can lump together high-interest loans into one monthly payment–making it that much more affordable. The money saved can be used to tackle paying off other debts–and lower your DTI.

FAQ about debt-to-income ratios

You can learn more about the impact and importance of DTI by exploring the frequently asked questions.

Does debt-to-income ratio affect credit score?

Although both your DTI ratio and credit score will affect your ability to get a loan, one piece of good news is that your DTI will have no effect on your credit score itself. Your credit score is all about your credit history.

How can knowing my DTI ratio help me?

Knowing your DTI ratio is helpful for avoiding decisions that will create too much of a pinch on your budget, such as falling into a state of “house poor,” which means you’re spending an uncomfortably high percentage of your income on your mortgage. Knowing your DTI ratio can also be great motivation to begin paying off debt to lower your DTI or assessing your odds of being approved for a loan.

What’s the difference between debt-to-income ratio and credit utilization rate?

Although these two calculations may sound similar, they are different. A credit utilization rate (or debt-to-credit ratio) evaluates how much of your credit you’re using (that is, your credit card balance) in comparison to your credit limit. Your DTI evaluates your monthly debt expenses compared to your monthly income.

The bottom line: A low debt-to-income ratio is a sign of financial health

Your debt-to-income ratio plays a big role in the loan approval process. It signals to lenders that you'll be able to pay off the loan. Emphasize that many lenders require a DTI lower than 36%.

To bring down your DTI, be sure to pay down balances, make a budget and track spending, say no to new debt, and consider debt consolidation. To pay down high-interest debt quicker – and potentially improve your DTI – a debt consolidation personal loan may be worth exploring.

If you’re ready to get a personal loan to help consolidate your debt, apply today with Rocket Loans^SM to find out what your monthly payment would be.