Deconstructing Your Debt-to-Income Ratio

October 17 2022

Use this tool to help keep your debt in check and improve financial wellness.

Your debt-to-income ratio (DTI) measures your monthly debt payment against your monthly income (before taxes or before other deductions have been made). To calculate your DTI, add your total monthly debt payments and divide them by your total pretax monthly income. For example, if you pay $200 monthly toward your car loan and another $800 toward your mortgage, your monthly debt payments are $1,000. If your pre-tax monthly income is $4,000, your DTI is 25% ($1,000 divided by $4,000).

Guidelines vary widely, but generally, a DTI of 35% or less is preferred by lenders (closer to 20% is ideal), whereas a DTI over 45% is likely to be problematic. Lenders use your DTI ratio to measure your ability to manage debt — so having a low DTI is very important, especially when buying a home, car, or other significant assets. The following are some ways to lower your DTI ratio.

Pay Off Debt

Surprise! While it’s easier said than done, reducing your debt can help you reduce your monthly payments and, therefore, the percentage of your monthly income going toward debt. Aside from lowering your DTI, paying off your debt can also improve your credit score by reducing your credit utilization ratio, which is your total debt divided by your total available credit. A higher credit score could help improve your chances of qualifying for a mortgage or getting a favorable interest rate.

Increase Your Income

Increasing your income is another way to reduce your DTI. You will have a higher gross income for the calculation and the opportunity to put more money toward your debt, which can further reduce your DTI. A few ways you might increase your revenue include working toward a work promotion, working overtime, or picking up a second job or side gig.

Lower Your Monthly Payments

You can reduce the percentage of your income used for debt by reducing your monthly debt payments. Several ways to lower your monthly payments include refinancing your loans or negotiating the interest rate on your debt. While dealing with your interest rate may be possible for credit cards, installment loans — like personal loans, auto loans, or student loans — will likely require a refinance to adjust the rate.

Reduce Your Nonessential Spending

Look where your money goes monthly and cut back as much as possible. For example, are you paying for subscriptions that you no longer need? Freeing up that extra money in your monthly budget means you’ll have more available to pay off debt. And the quicker you pay off debt, the faster you can reduce your DTI.

Increase Your Down Payment

When lenders calculate your DTI, they consider a mortgage loan’s impact on your finances and aim to keep your DTI with your mortgage under a certain level. You can reduce your DTI when you own a home by putting down a larger down payment, resulting in lower monthly mortgage payments.

If you have any questions regarding this topic, or would like to speak to one of our professionals on how you can begin optimizing your financial situation, reach out to us today!