Why Your Debt-to-Income Ratio Matters
Written by Jason Nelson on July 23, 2018
Just about everyone is aware that they have a credit score, and that banks use a credit score to determine your eligibility for loans and other services, but there is another number that is discussed far less often. The debt to income ratio, or DTI, is an equally important number that you need to be familiar with if you want to get a good loan. Here’s how it works and why it matters:
What is DTI?
Your debt to income ratio is essentially a way of comparing how much money you make versus how much money you are spending every month on your debt obligations. This number is presented as a ratio or a percentage of your total monthly income. For instance, if you make $2000 per month in gross income, but you spend $800 per month on credit card payments, rent, and student loans, then your DTI would be written as $800 / $2000 = 0.4. In other words, you have a 40% debt to income ratio because 40% of your gross monthly income goes directly toward your debts.
Now, imagine you are going to buy a car, and the payment on the car would be another $300 per month. This would increase your DTI to 55%. For many banks, this kind of DTI would be too high for them to consider the loan safe because it does not leave very much money for other living expenses like groceries, gas money, and utilities.
Why Debt to Income Ratio Matters
From the example above you can see why a bank would want to assess your debt to income ratio before giving you more money. If they believe that your DTI is too high, you may not be able to pay back the loan and continue to buy basic necessities. Your debt to income ratio provides a more complete picture of your financial status than a credit score alone, since your credit score mostly focuses on past payment history and total credit. Even a millionaire can have a very high DTI that disqualifies them from a favorable loan if they have too many car and house payments.
It is also important to know that your DTI can be read two ways. A front-end DTI refers only to the debt to income ratio of your housing. Industry standards indicate that a front end DTI should not exceed 30%. On the other hand, back-end DTI refers to all of your debt load, including your housing, which can go up to about 51% when accounting for a new home loan.
What Should Your DTI Be?
With all of the above, you’re probably wondering what a good DTI looks like. For most mortgage companies, a DTI around 36% or below is a very good number. However, most mortgage companies accept DTI ratios above this level if there is sufficient funds to back it up. In addition, a loan officer might ask you to pay down some smaller debts if it will get your DTI down and improve your interest rate.
If you have not been focusing on your DTI, but you do want to purchase a home in the near future, you will definitely want to figure out what your number is. Remember, the DTI is just as important as the credit score when it comes to securing a loan from a bank, so you don’t want to ignore it, even if you have made all of your payments on time.