Definition, calculation how to lower it
- The debt-to-equity ratio is a measure used by many lenders to determine the balance between your monthly income and the amount you owe to creditors.
- A good debt ratio is 36% or less. Knowing your debt-to-equity ratio (and keeping it low) can help you make the case for a better interest rate.
- You can lower your debt ratio by paying down your balances.
- Read more stories from Personal Finance Insider.
If you are applying for a loan or mortgage, one of the factors that lenders consider is your debt-to-income ratio (DTI).
Your DTI is an important factor in the borrowing process and shows lenders your ability to repay a loan.
What is the debt to income ratio?
Your debt-to-income ratio is the amount of debt you have relative to your income. This is an important consideration because when a lender approves a loan, they want to make sure you have enough income to repay the loan.
If you have a lot of debt that eats up a good portion of your income, this could be a warning sign.
How is the debt to income ratio calculated?
According to the Consumer Financial Protection Bureau (CFPB), “Your debt-to-equity ratio is all of your monthly debt payments divided by your gross monthly income. This number is a way lenders measure your ability to handle the payments you make. every month to repay the money you borrowed.”
Your gross income is the amount of money you earn before any tax deductions or deductions. Paying off your debts refers to the amount of money you spend each month on your loans.
Let’s say you earn $2,500 as gross income. Every month, you spend $200 on car loans, $250 on student loans, and $300 on credit cards. That means you’re spending $750 a month managing your debt repayments.
To determine your debt-to-income ratio, you need to divide your debt payments by your gross income:
$750 ÷ $2,500 = 0.3
Take that number and multiply it by 100 to get your debt ratio, which in this case would be 30%. In other words, 30% of your income is spent on your debts.
What is a good debt to income ratio?
If you’re heavily in debt and want to apply for a mortgage or other type of loan, you might be concerned about your DTI ratio. Each lender will assess your DTI, so you want to know what yours is and if it will prevent you from getting a loan.
But what is a good DTI ratio? A good benchmark is 36% or less. Many lenders use this metric to assess a borrower’s DTI. The smaller the number, the better.
Having a low DTI ratio can increase your chances of being approved for a loan. When it comes to mortgages, 43% is usually the highest DTI that will qualify you for a loan.
So if you want an accurate number, 36% or less is ideal. But the CFPB offers more specific DTI ratios for certain situations.
For example, he recommends that owners have a DTI of 36% or less (and absolutely no more than 43%), while renters should have a DTI of 15-20%.
Keeping your DTI ratio as low as possible will increase your chances of getting a mortgage, car loan, or other type of loan.
Lenders want to know that, given your current financial situation, you can afford to repay your current loans while taking out a new loan.
Your income plays a large role in what you can afford and the amount you pay each month significantly reduces your income. This is why your DTI is such an important metric for lenders when assessing your eligibility.
How to Calculate the Debt to Income Ratio
1. List all your monthly debt payments
Payments for car loans, student loans, mortgages, personal loans, alimony and child support, and credit cards are all considered monthly debt.
Notably, the calculation uses the combined minimum credit card payment of all credit cards, rather than the amount you actually pay each month. Utility bills, health insurance and
the costs are not considered debt.
2. Find your gross monthly income
Your gross monthly income is the amount of money you take home before taxes.
3. Divide monthly debt by monthly income
When you divide all monthly debt payments by gross monthly income, you get a decimal number. Move the decimal point two places to the right and you get your DTI percentage or ratio.
For example, let’s say Amelia wants to buy a house for the first time. His gross monthly income is $5,000, and his monthly repayments include a car loan of $300, minimum credit card payments of $100, and student loan payments of $400. Amelia’s debt ratio would be 16% ($800 / $5,000 = 0.16). With such a low debt ratio, it would probably favor
Although the DTI ratio is not related to your credit score – and therefore does not affect your credit report – the two have a fairly symbiotic relationship.
The two most important factors that rating agencies use to determine a credit score are payment history and current debt balance – they make up 65% of your credit score. Although credit bureaus do not have access to a person’s income, they are still able to consider past behavior to assess the likelihood of on-time payments.
Mortgage lenders generally have the strictest debt-to-income ratio requirements. Generally, 43% is the highest ratio a borrower can have while getting a qualifying mortgage. Some mortgage lenders, large and small, may still approve a borrower who has a debt-to-equity ratio above 43%, according to the Consumer Financial Protection Bureau, but they should make a “good faith and reasonable effort.” to determine repayment capacity.
How to lower your debt-to-income ratio
If you’ve done the math and your debt-to-equity ratio is above 36%, you’ll want to lower your DTI before applying for a loan. In order to reduce your debt ratio, you have two options:
- Pay down more of your debt
- earn more
The first option will require you to pay more than the minimum on your debt. Don’t take on any additional debt or reduce your current balances, so your debt doesn’t eat up as much of your income.
The second option is to increase your income. You can do this by negotiating your salary at your current job or by finding a side hustle to earn extra money.
Taking these steps to reduce your balances and increase your income will help your DTI go down. Once your DTI drops, you’ll be in a better position to apply for a loan.