Debt-to-Income Ratio: What it is and How to Lower Yours
Financial institutions assess the finances of loan applicants using a number of measures, and one of the most important is debt-to-income ratio. Debt-to-income ratio sets the debts an individual holds against the income they have coming in, and so reflects their financial responsibility and ability to meet financial obligations reliably.
The following article takes a look at debt-to-income ratio and provides some tips on how to lower your ratio.
What is Debt-to-Income Ratio (DTI)
Debt-to-income ratio is a measure that compares the amount you owe each month to the amount you earn each month. Your monthly debt is comprised of the central financial obligations you must meet each month, like rent, car payments, and credit card payments. Your monthly earning is the income you earn each month before tax.
Your debt-to-income ratio, then, is the percentage of your income that is devoted to recurring monthly expenditures.
Why is Debt-to-Income Ratio Important?
Debt-to-income (DTI) ratio is one of the most valuable metrics determining financial health because it reflects your ability to make payments on time and manage finances responsibly.
If your DTI ratio is low, that means that you aren’t spending beyond your means and that you have the funds available to make payments on time. If you have a high DTI ratio, on the other hand, your monthly expenses are approaching or exceeding your income.
Financial institutions value debt-to-income ratio because it tells them not just what you earn, but how responsibly you spend what you earn. Debt-to-income ratio is one of the central considerations a financial institution will make when evaluating a loan application, for instance.
How to Figure out Debt-to-Income Ratio?
Debt-to-income ratio is calculated using your monthly expenses and your monthly income.
First, add up recurring monthly payments, including:
- Monthly credit card payments
- Monthly house payment or rent
- Monthly child support or alimony
- Student loan payments
- Auto loan payments
- Any other debts
Expenses like gas, taxes, utility payments and groceries are usually excluded from this calculation.
Then, take the total that you came up with from the previous step and divide it by your gross monthly income, meaning your monthly income before taxes.
The number you get from that calculation is your debt-to-income ratio, expressed as a percentage.
3 Tips for Lowering Your Debt-to-Income Ratio
Pay Down Debt More Aggressively
Since your total recurring debt is one of the primary factors determining your debt-to-income ratio, reducing this debt by paying off your debts quickly is one of the best ways to lower your debt-to-income ratio. Rather than paying the minimum on your credit card or your student loans, allocate an extra amount to put towards your debts each month. Even if it’s a small amount, over time it can significantly lower your debt-to-income ratio.
Avoid Making Large Purchases
A high debt-to-income ratio means the balance of money coming in and money going out is askew. Large purchases can skew this balance further, and cut into your funds for making monthly payments. By avoiding large purchases you can keep total expenses down and pay off your debt quicker. The more debt you hold or loans you have taken out, the more conservative you should be.
Avoid Taking On More Debt
Some debt is less avoidable, like house payments or student loans for instance, but other debts you can avoid with sound financial planning. Credit card debt, in particular, is often troublesome because it allows you to disconnect your spending from your income at the cost of very high interest rates. You should avoid using credit cards as much as possible, and limit other debts you take on until your debt-to-income ratio is lower.
Debt-to-income ratio is one of the first metrics financial institutions will use when judging an application, and it is also useful in helping you understand your overall financial health. Once you understand how to calculate DTI ratio you should track it closely over time and see if you are making progress in paying off your debts. If not, by taking the steps above you can begin improving your DTI ratio.