Understanding Debt-to-Income Ratio
A high Debt-to-Income (DTI) ratio can make it harder to secure a loan. But what exactly is the DTI ratio and how is it calculated? Let’s take a look.
Even with a very good credit score, it can be challenging to obtain a loan if your DTI ratio is too high. The DTI ratio measures how much of your monthly income goes toward debt payments. To calculate your DTI, add up your monthly debt payments (like your rent or mortgage, car loan, credit cards, or student loans) and divide that number by your gross monthly income. Multiply by 100, and you’ve now got your percentage.
Calculate Your DTI
Here is an example to help you calculate the DTI ratio. Let’s say Sarah is trying to calculate her DTI ratio before applying for a car loan. Below is a breakdown of Sarah’s monthly payments (do not include living expenses such as utilities, groceries, car insurance, or entertainment) and income:
- Rent or Mortgage payment: $1,200
- Student loan payments: $300
- Credit card minimum payments: $400
- Sarah’s total monthly debt payment is $1,900: $1,200 + $300 + $400 = $1,900
- Gross monthly income: $5,500
- To determine her DTI ratio, divide her total debt payments by her gross income: $1,900 ÷ $5,500 = 0.35
- Sarah’s debt-to-income ratio is 35% (multiply .35 by 100)
If you would like assistance calculating your DTI ratio, contact a UECU Financial Services Consultant at 800-288-6423.
Why Does DTI Matter?
Lenders look at DTI when deciding whether you can handle more debt. The 28/36 rule is a guideline for determining a healthy DTI. It suggests spending no more than 28% of gross monthly income on housing and no more than 36% on total debt payments. If the DTI is too high, loan approval could be more difficult, or higher interest rates might be offered, which is not going to do you any favors when it comes to saving for the future.
How Can You Lower Your Debt-to-Income Ratio?
There are a few ways to lower the DTI ratio. And, while it can take time, remind yourself that each small step you take is progress made.
- Increase Your Income: Freelancing, selling items online, or joining the gig economy are a few ways to bring in additional earnings. Even small side-hustles can make a difference. Maybe you deliver groceries in your neighborhood and use the extra income to pay off a small credit card balance quickly. You’ve now reduced your DTI ratio and improved cash flow.
- Reduce Your Debt: Focus on paying off smaller debts first or reducing high-interest balances. For those with multiple high-interest payments, debt consolidation for a high debt-to-income ratio might be one solution. By consolidating debt into one lower-interest loan, monthly payments become more manageable, which helps reduce the DTI ratio over time.
- Refinance or Consolidate: By refinancing your mortgage, student loans, or auto loans, you can reduce the monthly payments and free up some breathing room in your budget. On the same front, consolidating credit card debt into a single loan with a lower rate simplifies your payments, allowing you to tackle your debt more efficiently.
- Create a Budget: Start by listing all your monthly income and expenses to see where your money is going. Then, look for areas where you can cut back or downgrade subscriptions on non-essential spending, such as food delivery, streaming services, or subscriptions. Direct the money saved toward paying off your debts faster. By sticking to a budget, you can slowly reduce your DTI ratio.
Common Questions About Debt-to-Income Ratio
- Can You Use a Personal Loan to Pay Off Debt? Yes, a personal loan can be used to pay off debt, especially if high-interest credit cards are involved. However! Before you go this route, you’ll want to compare interest rates and fees to make sure the personal loan is a better deal than the current debt—because the last thing you want to do is add to your existing financial burden.
- Does Lowering Your Debt-to-Income Ratio Raise Your Credit Score? Although the DTI ratio doesn’t directly impact a credit score, lowering it can still help in the long run. Paying off debt reduces credit utilization, which is a major factor in credit scores. Over time, this can lead to improvements in both DTI ratio and credit scores.
- How Can You Get Out of Debt with a Low Income? Even with a limited income, it’s possible to work toward becoming debt-free. Focus on making small, consistent payments and finding ways to trim or renegotiate discretionary expenses. Exploring options like a Debt Management Program can also help by lowering interest rates and simplifying payments. By consolidating payments into one easy-to-manage plan, it becomes possible to reduce the DTI ratio and work toward financial comfort.
UECU members can receive free financial education and debt counseling services through GreenPath Financial Wellness, a nonprofit organization. A financial counselor will help you create a budget, review your credit report, and discuss debt repayment options. Get started at www.GreenPath.com/UECU or call 877-337-3399. The call is free and confidential.
