What Is Debt To Income Ratio?
Ready to buy a car? Or a house? Or maybe you need some spending room and need to open a credit card. To take the next step, financial institutions will look at your past and current financial situation and calculate your debt to income ratio, or DTI. This determines how much debt you currently have and can affect how much you can take on in the future. Learn how to calculate it and understand what it means for future loans.
What Is It?
Ready for a reliable vehicle but need a loan to secure your purchase? DTI ratio is considered by lenders when deciding to approve your desired loan amount. To calculate this and get your magic number, you need to follow this formula:
Monthly Debt / Monthly Pretax Income x 100
Most lenders will accept a DTI of 43% or less, but it is best to have as small of a percentage as possible. The higher the percentage, the more risk the lender is taking on - plus it means the additional debt you take on may not be manageable.
Show Me The Numbers
For example, let’s say you need a car. You found the perfect minivan on the lot, but to bring it home you need a loan of $10,000. Various factors go into a lender’s decision to loan money such as credit score, credit history, and DTI.
With a current monthly income of $4,000 pretax, in this example, your current monthly debt situation looks like this:
- Mortgage - $1,500
- Student Loans - $300
- Credit Card - $400
- TOTAL = $2,200
If you plug these numbers into the formula listed above, it will look like this: 2,200/4,000 x 100.
Once you do the math, your DTI ratio percentage is 55%. This means the lender will probably not give you the loan at this time. If you increase your income or decrease your debt as shown in this example, you are more likely to get approved for the loan.
Why It Matters
The better your DTI, the more likely a lender is to approve your loan. The bonus is if you have a lower DTI, the debt you take on will be more manageable, and you won’t struggle as much to pay the amount back.
To make your DTI even better before applying for a loan, evaluate your current debt and look for ways to reduce it.
- Consolidate your debt
- Payoff a loan
- Stop using your credit cards
Taking these steps will make it easier for lenders to give you a loan, plus simplify your current debt situation.
Before you apply for a new loan or credit card, evaluate your current financial situation – look through the eyes of your lender. Are you a good risk? Or, do you need to work on your finances before taking on more debt? Seeing the big picture will help you make future important financial decisions.