What is Debt-to-Income Ratio?

Debt-to-income ratio is a calculation lenders use when approving new credit cards, loans and lines of credit. This ratio is based on your debt obligations and income, as the name implies. The number is an indication of your ability as a borrower to make payments on a new loan and any existing debts.

Because this number can make or break your next loan application, it is important to understand. You can even calculate your own debt to income, sometimes called DTI, to see how you stand. Read this guide to learn more.

What does debt-to-income ratio mean?

Here’s the definition of debt-to-income ratio, according to Investopedia:

The debt-to-income (DTI) ratio is a personal finance measure that compares an individual’s monthly debt payment to his or her monthly gross income. Your gross income is your pay before taxes and other deductions are taken out. The debt-to-income ratio is the percentage of your gross monthly income that goes to paying your monthly debt payments.

Another way to think about debt-to-income is your recurring debt payments as a percentage of your monthly income. A higher proportion of debt compared to income results in a higher DTI. A higher debt to income is considered a bigger risk by lenders.

Here is a short video from the CFPB that explains more about how debt-to-income works:

Your debt-to-income ratio usually includes the following debts at minimum:

• Mortgage loan and auto loan payments
• Student loan payments
• Credit card payments
• Other items you may have financed that report to the credit bureaus
• Other personal loans

This ratio does not generally include other living expenses, housing expenses, utilities, property taxes and other costs that are not typically included on your credit report.

How to calculate your debt-to-income ratio

Calculating your debt to income ratio is easy. If you can do basic addition and division using the calculator on your phone, or any other calculator, you can calculate your DTI.

To start, you’ll need to know your annual income before taxes and deductions. If you don’t know this number, you can find it on a pay stub or your most recent W-2 form used to file your taxes.

Next, you need to find your total monthly minimum debt payments. You can find this on your credit report, which you can usually get a version of for free from sites like Credit Karma, Credit Sesame, or maybe your bank.

When I worked as a bank manager, I used the minimum monthly payment on the credit report but did not include debts where the applicant was an authorized user. Most people’s debt included things like a mortgage, credit cards, student loans, car loans and lines of credit.

Add up your monthly payments on your credit report and divide by your gross monthly income to get your debt to income ratio. For example, if you make $40,000 per year that’s the same as $3,333.33 per month. If you have $500 in monthly debt payments, your debt-to-income would be 500/333.33 = .15. In this case, your DTI is .15 or 15%.

If that looks too complicated, here’s a handy little debt-to-income ratio calculator you can use.

Debt-to-income and your credit score

Contrary to the belief of some, your income has no direct impact whatsoever on your credit score. You can earn nothing and have a perfect credit score or earn six-figures and have a terrible credit score.

Your credit score is only based on your current debt and history of debt payments and credit-related records. Your income only influences your credit indirectly, as it impacts your ability to pay for your loans each month. But ultimately, it is your debt balances, debt history and any history of public records that make up your credit score.

Your debt-to-income ratio does likely follow your credit utilization ratio closely, which is a metric used in your credit score. Credit utilization is the percent of credit used in relation to your credit limits.

How lenders use the debt-to-income ratio

Most mortgage lenders require a debt to income ratio of 43% or lower, though some prefer a DTI of 36% so you have some flexibility to get your application through. A higher down payment lowers your monthly loan payment if you are struggling to get approved.

As a general rule, a DTI lower than 30% is considered good by lenders in most industries. Each lender has its own specific requirements and rules for what it counts and what gets removed when calculating a customer’s debt-to-income ratio and approving a new application.

Never lose track of your DTI

Your debt-to-income ratio is likely not inclusive of all monthly expenses, so it is just one estimate used to decide if you can afford a loan and are likely to pay it back. The lender will use your credit report, credit score, debt-to-income ratio, and other factors to approve any new loan application. No lender would make any decision with just one consideration in a nutshell.

By keeping track of your debt-to-income ratio, as well as your overall monthly living expenses, you will be in the best position to qualify for whatever future loan you’re looking for. But don’t lose track of your credit score or other aspects of your finances. It takes the full package to truly master your money.

About the author

Eric Rosenberg is a former bank manager and corporate finance worker. His work is featured at Business Insider, Credit Karma, The Balance, Investopedia, and many other fine websites and publications.