Your ability to handle debt is crucial to lenders when they're deciding whether to lend you or your business money. That's why they need to know about your current debt before approving any loans or credit lines. This is where the debt-to-income (DTI) ratio comes into play.
Your DTI ratio looks at how much money you make compared to how much you're spending on debt. A lower ratio means you have fewer debts and are more likely to handle additional debt without as much risk compared to someone with a higher DTI ratio. When your DTI ratio is low, it increases your chances of getting approved for financing.
Summing up: What is a good debt-to-income ratio?
- The debt-to-income (DTI) ratio measures how much of your income or revenue goes toward debt payments, with lower ratios signaling better financial health and higher chances of loan approval.
- To calculate your DTI ratio, list all monthly debt obligations and divide them by your gross monthly income.
- While a DTI ratio below 36% is viewed favorably, DTI ratios exceeding 50% pose challenges in securing financing, necessitating strategies to reduce debt and improve financial standing for better borrowing prospects.
How to calculate your debt-to-income ratio
Calculating your debt-to-income (DTI) ratio involves a few straightforward steps:
1. Begin by listing all your monthly debt obligations. These are the fixed payments you need to make regularly to keep your financial obligations in order. Make sure to include items like:
- Rent or mortgage payments
- Auto loans
- Student loan repayments
- Minimum credit card payments
- Any other personal loan commitments
2. Next, tally up your gross monthly income, which is your income before taxes and other deductions. This should encompass your primary salary from full-time employment and any additional income from side gigs, freelance work, or other business ventures. Depending on your lender, you might need to provide supporting documentation such as tax returns or bank statements demonstrating consistent income deposits to validate your income.
3. Once you have your total monthly debt payments and gross monthly income, divide the former by the latter to arrive at your DTI ratio. This calculation yields a percentage representing the proportion of your income that goes toward servicing debt. For instance, if your monthly debt payments amount to $5,000 and your gross monthly income stands at $12,000, your DTI ratio would be $5,000 divided by $12,000, which equals 41.7%. This figure offers insight into how much of your income is dedicated to debt repayment, helping lenders assess your financial stability and determine your eligibility for additional credit.
What is a good debt-to-income ratio?
Understanding what lenders look for in a debt-to-income ratio can help you determine how your DTI ratio might influence your ability to receive personal or business financing in the future.
Debt-to-income ratio is less than 36%
Lenders generally regard a debt-to-income (DTI) ratio below 36% as favorable, indicating that your debt load is manageable. This percentage suggests you earn enough monthly to comfortably cover your debt obligations without risking missing payments. It reflects a healthy balance between your income and debt, providing financial stability and reducing the likelihood of encountering financial difficulties.
Debt-to-income ratio is between 36% and 42%
Lenders perceive a debt-to-income (DTI) ratio between 36% and 42% with cautious consideration. While falling within this range doesn't necessarily indicate financial distress, it suggests a slightly higher level of debt relative to income. This range may still be acceptable to lenders, particularly if other aspects of your financial profile, such as credit history and assets, are strong. However, borrowers with DTI ratios in this range may encounter more scrutiny during the loan approval process and might face slightly higher interest rates or more stringent borrowing conditions.
Debt-to-income ratio is between 43% and 50%
As your debt-to-income (DTI) ratio edges toward 50% within the 43% to 50% range, lenders start seeing you as someone who might face challenges in managing additional debt. While it's still possible to secure financing, your chances become slimmer.
In this range, it's wise to consider strategies for debt reduction and improving your financial health before pursuing new loans or mortgages. By proactively lowering your DTI ratio through debt repayment, you not only enhance your eligibility for future borrowing but also gain greater financial flexibility and peace of mind.
Debt-to-income ratio is over 50%
Once your debt-to-income (DTI) ratio surpasses 50%, you're entering territory where securing financing becomes increasingly challenging. At this threshold, lenders become cautious and may be hesitant to extend additional credit due to concerns about your ability to manage further debt obligations. This heightened level of leverage raises red flags, signaling to lenders that you may struggle to meet payment obligations. At this point, it's crucial to address existing debt and work towards reducing your DTI ratio.
One option to support lowering your DTI ratio is selling off assets to pay off debt, like selling a newer car to buy an older vehicle in cash. If you've already cut expenses, you may instead set your sights on finding new sources of income, whether by taking on a side gig or increasing marketing efforts for a small business. Taking these actions can help improve your financial standing and increase your chances of obtaining financing in the future.
Improve your debt-to-income ratio with BHG Financial
A personal debt consolidation loan is another way to lower your debt burden. These loans for individuals and businesses can bring together all of your debt into a single, predictable monthly payment. And with extended repayment terms of up to 10 years1,2, you may be able to lock in a low, affordable payment.
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Debt-to-Income Ratio FAQs
What is too high for a DTI ratio?
A debt-to-income (DTI) ratio above 50% is generally considered too high. At this level, borrowers may encounter significant challenges in managing their debt obligations and face difficulties securing financing. Lenders may be reluctant to extend credit to individuals with DTI ratios exceeding 50% due to concerns about their ability to make timely payments.
What should not be included in DTI?
When calculating your DTI ratio, don't include regular living expenses like groceries, utilities, insurance premiums, and discretionary spending like entertainment and eating out. Additionally, expenses related to savings and investments, such as contributions to retirement accounts or investment portfolios, are generally not factored into the DTI ratio calculation. Instead, DTI focuses specifically on debt obligations such as mortgage or rent payments, loan payments, credit card minimum payments, and other fixed monthly debt payments.
