What is debt-to-income ratio?

Managing your money can take a lot of juggling, and one of the biggest things to juggle is how much money you owe versus how much money you make. This is called your debt-to-income ratio. Lenders can use this ratio to get a better picture on whether you can take on more debt, like a car or house loan. So, let’s talk about debt-to-income ratio, how to calculate it, and why it matters so much for managing your money.

How is debt-to-income ratio calculated?

To figure out your debt-to-income ratio, first add up all the money you owe each month. That means rent, loans, bills, takeout, gas, everything you spend money on. Now divide that final number by how much money you earn before taxes. Let’s say you owe $1,100 every month and earn $2,500. When you divide $1,100 by $2,500, your debt-to-income ratio comes out to 44%. A little steep, but we’ll get into that.

There are two types of debt-to-income ratios: “front-end” and “back-end.” Front-end only looks at how much money you spend on housing, like rent or mortgage payments. The back-end looks at pretty much everything else you spend money that contributes to your monthly debts.

If you’re calculating your own debt, be mindful of how you’re tracking your spending. Are you checking your debit card statement and adding up every expense in a month? Are there some expenses that you always pay for in cash? Is the month you’re using to calculate your debt different in its spending, like you had to buy a bunch of holiday gifts or your car broke down and had major mechanic expenses this month? No matter what, it’s never too nerdy to get a good spreadsheet going!

What is a good debt-to-income ratio?

Generally, having a debt that's less than 36% of your income each month is good. But sometimes the loan you want might dictate what your debt-to-income ratio should be. For example, a mortgage loan might require less debt than a car loan since you can pay a mortgage loan back over a much longer period of time. Some lenders might be okay with more debt if you have a good credit score and steady income. Just remember, having a high debt-to-income ratio, or a lot of debt compared to how much money you’re making each month, can mean a tougher time getting approved for loans, which could also mean higher interest rates.

Why is debt-to-income ratio important?

Debt-to-income ratios matter to both lenders and borrowers. If a borrower has a high DTI, that means they have a lot of debt and may struggle to pay loan payments back each month. If the borrower seems riskier to a lender, then they might have to pay higher interest or not get the loan at all. Lenders are always assessing risk and are more likely to loan money when it’s more likely that they’ll get the money back.

How to improve your debt-to-income ratio

If you have a high debt-to-income ratio, here are a few strategies you can use to help lower it:

Make a budget

The first step to lowering your debt-to-income ratio is knowing what your ratio is, and the first step to finding that out is calculating your monthly spending. Once you do that, you have the basics of a budget already in place. Now you can decide what’s essential each month and what unnecessary expenses you can cut out, so you have more money to put towards your debt.

Pay off existing debt

The best thing you can do to improve your debt-to-income ratio is pay off your current debt. This might not be such an easy task, but it’s a hugely important one since it will lower the amount of money you have to pay each month over time, steadily decreasing your debt-to-income ratio.

Avoid taking on new debt

If you owe a lot compared to how much you make, stay away from taking on more debt. Accumulating more debt will only make your monthly payments even higher, making it harder to close that growing gap in your debt-to-income ratio. Instead, work on paying off your existing debt, stick to your budget, cut out unnecessary expenses, and stretch your income to cover more crucial expenses before taking on more debt.

So, are you ready to figure out your debt-to-income ratio? More importantly, are you ready to get your debt-to-income ratio to a sweet spot that lenders won’t find too risky? We believe in you! Now start budgeting…