Debt-to-Income (DTI) ratio is a personal finance measure that helps in identifying an individual’s debt payment in comparison to their overall income. It is a way through which a lender can determine your ability to repay the money that you have borrowed.
It is important that you do not confuse DTI with your credit card utilization, which is the amount of debt that you have accumulated in relation to your credit limits. Several lenders, especially mortgage or auto loan lenders, make use of your debt-to-income to determine your ability to pay them off responsibly. For example, a mortgage lender will use your DTI ratio to figure out how much of the mortgage you can afford to pay after all other monthly debts are paid off.
You can easily calculate your debt-to-income ratio to determine how much debt you have to pay off. To calculate your DTI ratio, add up all the monthly debt payments that you have and divide that sum by your gross monthly income. The gross monthly income that you accumulate is usually the money that you have earned before the taxes and other deductions are taken out.
Three Levels of Debt-to-Income Ratio
In the world of credit counseling, DTI ratio has three levels. It is very similar to a traffic light, green is safe, yellow is caution, and red is danger level.
- <15% GOOD
- 15% - 20% CAUTION
- >20% DANGER
15 percent level
At this level, you have enough income to devote towards the household expenses and such. Even unexpected expenses can be covered with this percentage.
15-20 percent level
At this level, though you can probably keep your head above water, it is always better to be safe than sorry. At this level, an individual will probably need to get a self-payment method like the debt ladder or debt snowball (paying off small debt first and working your way up) and to discipline themselves to stay above the debt. Slipping to this level can be troublesome.
20 percent and above
This level is the most dangerous level a consumer can fall into. At this level, it will become clear to you that your financial situation is not healthy. If your DTI is 20 percent or above, you have more debt than you can actually afford. At this level, it is always best to get help from a credit counselor.
Lowering Your DTI Ratio
There are two ways of lowering your DTI ratio:
- Reduce the monthly debt
- Increase the amount you pay each month
A low DTI ratio indicates a good balance between your debt and income. A high DTI ratio gives you a bad reputation of having a higher debt than the amount of gross monthly income. Studies show that a consumer with a lower debt-to-income ratio is more likely to be successful in paying off their debts monthly.
Debt-to-Income Ratio Effect on Mortgage
Lenders such as mortgage lenders use your DTI ratio to measure your ability to make payments in a timely manner every month. When you are applying for a mortgage, the lender will first go through your finances before approving your request. Your finances will include your credit history, gross income monthly, and the amount of money you have on hand for a down payment. Your DTI ratio will be looked over to figure out how much you can afford to pay every month. A lender can deny your application based on your monthly expenses for the household and other debts being higher than your monthly income.
Does Your Debt-to-Income Ratio Affect Your Credit Score?
A credit score is a numeric expression that helps estimate the risk of extending the credit or loaning money to people. Your DTI ratio doesn’t affect your credit score directly, as the credit agencies are unaware of your monthly income. However, they do look over your debt-to-credit Ratio. This is calculated in the same way, dividing your credit card balance with your credit limit. This means that if a person owes more than their credit limit, then their credit score will be lower.
Both your debt-to-income and debt-to-credit ratios are used to conclude whether you qualify for a mortgage or not, but only the debt-to-credit directly affects your credit score.
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