Before approving you for new credit, lenders will likely first look at your credit report, your credit score and something called your debt-to-income ratio — commonly referred to as DTI.
While all these factors help show your likelihood to repay the money you borrow, your DTI shows whether or not you have the means to actually afford repayment. As it's expressed, a "debt-to-income" ratio is how much debt you have relative to your income.
Lenders look at your DTI to see what amount of your monthly income goes toward the debt obligations you already have. A low DTI indicates that you earn more than you owe, whereas a high DTI means that more of your paycheck goes toward paying your debts.
How to calculate your debt-to-income ratio
To calculate your DTI, divide your total monthly payments (credit card bills, rent or mortgage, car loan, student loan) by your gross monthly earnings (what you make each month before taxes and any other deductions).
For example, here's what your monthly payments may look like:
Mortgage: $1,500
Car loan: $500
Student loan: $320
Credit card minimum payment: $180
Total monthly bill payments: $2,500
If your monthly debts total $2,500 and your gross monthly income is $5,000, your DTI calculation would look like: $2,500 / $5,000 = 0.5. To get the ratio as a percentage, you would then multiply 0.5 x 100 = 50%. Your DTI would be 50%.
The ideal DTI varies by lender, type of loan and loan size. Generally, a DTI of 20% or less is considered low and at or below 43% is the rule of thumb for getting a qualified mortgage, according to the CFPB. Lenders for personal loans tend to be more lenient with DTI than mortgage lenders. In all cases, however, the lower your DTI, the better. A lower DTI shows you make more than you owe and can therefore afford to take on more debt while keeping up with the monthly payments you already have.
How to improve your debt-to-income ratio and help your credit score
Your income isn't included on your credit report, but lenders will often ask you to include it on any loan application, as well as show proof of income.
Because your DTI doesn't show up on your credit report, it won't necessarily affect your credit. Actions you take to lower your DTI, however, can in turn help your credit score.
One obvious way to lower your DTI is to reduce your total debt load. If you can, pay off your credit card balances or any other loans, or at least chip away at the balances when possible. Getting rid of your outstanding credit card debt also helps to lower your credit utilization rate, which looks at how much of your available credit you use. A low utilization rate is essential to having a good credit score, and it makes up 30% of your score calculation.
A debt consolidation loan might make it easier for you to reduce your debt faster by streamlining your monthly credit card payments into one bill. Qualifying for a lower monthly payment can also help to lower your monthly debt obligations, and thus lower your DTI. We rated Happy Money as the best personal loan for debt consolidation because it charges no early payoff fees and no late fees.
Keep track of your credit score as you improve your debt-to-income ratio
Since your credit score plays a big role in whether or not you get approved for new credit, keeping track of it is just as important as working on improving your DTI.
Credit monitoring services help you stay alert of any changes to your credit by notifying you in real time, as well as helping you spot fraud early on. CreditWise® from Capital One is a free credit monitoring service that is open to anyone — regardless of whether you're a Capital One cardholder. It also offers dark web scanning and social security number tracking, plus a credit score simulator tool. As you plan to pay off any debt in hopes to improve your DTI, you can see how these efforts also help your credit score.
Increasing your income is another way to improve your DTI. Consider asking for a raise at work, finding a side hustle you can do at nights or on the weekends or leaving your job for one that pays you more.
Keep in mind that when you do get approved for that new credit you've been wanting, your DTI will increase since you are taking on more debt. This can influence your ability to borrow more in the future.
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FAQs
How do I calculate my debt-to-income ratio? To calculate your DTI, you add up all your monthly debt payments and divide them by your gross monthly income. Your gross monthly income is generally the amount of money you have earned before your taxes and other deductions are taken out.
How to calculate your debt-to-income ratio? ›
How do I calculate my debt-to-income ratio? To calculate your DTI, you add up all your monthly debt payments and divide them by your gross monthly income. Your gross monthly income is generally the amount of money you have earned before your taxes and other deductions are taken out.
How do you calculate debt ratio? ›
A company's debt ratio can be calculated by dividing total debt by total assets. A debt ratio of greater than 1.0 or 100% means a company has more debt than assets while a debt ratio of less than 100% indicates that a company has more assets than debt.
Is 40% a good debt-to-income ratio? ›
35% or less is generally viewed as favorable, and your debt is manageable. You likely have money remaining after paying monthly bills. 36% to 49% means your DTI ratio is adequate, but you have room for improvement. Lenders might ask for other eligibility requirements.
How to calculate ability to pay? ›
The factors used to determine the ability to repay include the borrower's current income and assets. They may also include reasonably expected income. The borrower must also provide verification of this income and their employment status. Besides income, lenders must consider a borrower's current liabilities.
What is a realistic debt-to-income ratio? ›
35% or less: Looking Good - Relative to your income, your debt is at a manageable level. You most likely have money left over for saving or spending after you've paid your bills. Lenders generally view a lower DTI as favorable.
What bills are included in the debt-to-income ratio? ›
These are some examples of payments included in debt-to-income:
- Monthly mortgage payments (or rent)
- Monthly expense for real estate taxes.
- Monthly expense for home owner's insurance.
- Monthly car payments.
- Monthly student loan payments.
- Minimum monthly credit card payments.
- Monthly time share payments.
The monthly debt payments included in your back-end DTI calculation typically include your proposed monthly mortgage payment, credit card debt, student loans, car loans, and alimony or child support. Don't include non-debt expenses like utilities, insurance or food.
What is the formula for bad debt ratio? ›
Calculating the percentage of bad debt
Divide the amount of bad debt by the total accounts receivable for a period, and multiply by 100.
Why do we calculate debt ratio? ›
Investors use the ratio to evaluate whether the company has enough funds to meet its current debt obligations and to assess whether it can pay a return on its investment. Creditors use the ratio to see how much debt the company already has and whether the company can repay its existing debts.
Rent is an expense, and it can be a liability, but it is not a debt unless it is overdue. Rent and mortgage interest are in the same class of expense. But then mortgage interest is not a debt either.
Is a 7% debt-to-income ratio good? ›
DTI is one factor that can help lenders decide whether you can repay the money you have borrowed or take on more debt. A good debt-to-income ratio is below 43%, and many lenders prefer 36% or below. Learn more about how debt-to-income ratio is calculated and how you can improve yours.
What is a good debt-to-income ratio to buy a house? ›
According to the Federal Deposit Insurance Corp., lenders typically want the front-end ratio to be no more than 25% to 28% of your monthly gross income. The back-end ratio includes housing expenses plus long-term debt. Lenders prefer to see this number at 33% to 36% of your monthly gross income.
How to lower debt-to-income ratio? ›
How do you lower your debt-to-income ratio?
- Increase the amount you pay monthly toward your debts. ...
- Ask creditors to reduce your interest rate, which would lead to savings that you could use to pay down debt.
- Avoid taking on more debt.
- Look for ways to increase your income.
Apply for a secured personal loan: If your DTI is too high, another way to qualify for a loan is to apply for a secured personal loan rather than an unsecured one. With a secured loan, you have to use some form of property as collateral, such as your car or bank account balance, to secure the loan.
What is the 28 36 rule? ›
According to the 28/36 rule, you should spend no more than 28% of your gross monthly income on housing and no more than 36% on all debts. Housing costs can include: Your monthly mortgage payment.
What is a good debt ratio? ›
If your debt ratio does not exceed 30%, the banks will find it excellent. Your ratio shows that if you manage your daily expenses well, you should be able to pay off your debts without worry or penalty. A debt ratio between 30% and 36% is also considered good.
What is a good debt-to-income ratio for buying a house? ›
A good DTI ratio to get approved for a mortgage is under 36%, but it's possible to qualify with a higher ratio. Barbara Marquand writes about mortgages, homebuying and homeownership.
