What is Debt-to-Income Ratio and How to Calculate It?
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Learning about the ins and outs of personal finance can be a difficult process as there is a lot to learn. However, if you want to be financially healthy, it’s important that you are informed. One helpful personal finance tip that everyone should know about, but very few do, is the debt-to-income ratio (aka DTI ratio). The DTI ratio not only provides you with information about your financial standing, but it’s also an integral part of the borrowing process.
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What is Debt-to-Income Ratio?
So, what exactly is a debt-to-income ratio? It is a personal finance calculation that looks to compare a person’s debt payments every month to their income every month. The number is very important to know for several reasons. The biggest one is that lenders will often use this ratio to see how you can manage monthly debt payments. This means that if you have a better ratio, there is a better chance that lenders will trust you with their money.
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It is also important for you to know your own DTI ratio. This is because it can help give you a simple and clear look at how well you are managing and handling your debt every month. Sometimes, we don’t see just how much we are spending on our debt unless it is staring us right in the face. Seeing this ratio can be a wakeup call for people who have far too much debt compared to their income.
How do you Calculate Your Debt-to-Income Ratio?
Now that you know what a debt-to-income ratio is, how do you go about calculating it? Thankfully, it is a fairly simple process and shouldn’t take you that long at all to figure out. It is calculated by dividing the debt payments you make each month by how much money you make each month, the number is normally presented as a percentage.
For example, if you make $4,000 a month and have debt that includes a $1,000 mortgage payment and a $500 car loan payment, you will have a debt-to-income ratio of 37.5%. So, the calculation we made for that was $1,500 (your total recurring monthly payment for debts) divided by $4,000 (your gross monthly income). We got .375, and then we turn that number into a percentage and get 37.5%!
But the question you are probably asking is “what does that number mean”? If you have a low DTI ratio, you have a good balance between debt and income and are in no real danger of not being able to keep up with your debt, even if an emergency comes up. However, if you have one that is high, it can sometimes signal that you are carrying too much debt for how much money you are making. Also, having a high DTI ratio can simply make it hard for you to pay bills every month with so much of your income going to your debt payments.
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What is a Good Debt-to-Income Ratio?
As for what is considered a good DTI, that can be fairly subjective depending on wages and the type of debt you have, but there are a few general rules and guidelines that you can follow. In general, anything over 50% and you have far too much debt for your income. The highest you can have and still qualify for a mortgage is in the low 40s and this will differ depending on who you lend with. Having a DTI ratio in the mid to low thirties is normally ideal and anything lower than that is difficult to achieve if you have a car payment or mortgage. Simply put, the lower the number, the better off you will be and the better chance you will have at securing a mortgage, car loan, or any other type of loan you may be interested in.
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How to Improve Your Debt-to-Income Ratio
Now that you are able to calculate your DTI ratio you are likely in one of two camps. Either you have a fairly low or manageable DTI ratio and are feeling pretty good about yourself or you have a high DTI ratio and are starting to worry and stress. Either way, there is no reason to worry, as it’s a fairly simple process to lower your DTI ratio.
Basically, there are three different ways to lower and improve your debt-to-income ratio and they are to eliminate or reduce the monthly recurring debt you have, increase the income you make per month, or a combination of the two. While this sounds simple and easy, it is not always simple to go out and make more money or to reduce your debt. You need to make specific lifestyle changes and be conscious of these things going forward. It is easy in principle, especially when compared to raising your credit score, which can take a while and can be hard to predict. However, it does indeed take some considerable lifestyle changes for most people.
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Tips for Improving Your Debt-to-Income Ratio?
In order to make things a bit easier for you, we have decided to include a few specific tips about things you can do to improve income and lower debts. As we mentioned, it’s all about lowering debts and raising income, but that is pretty broad, so here are some real-life examples that should help.
Rent Your Space or Items
If you own a home, one of the best ways you can help lower your DTI ratio is to rent out a room or area of your home. Most of the time, this could potentially cover most, if not all, of your mortgage payment, which is one of the most common reasons for a high DTI ratio. It would essentially be lowering your mortgage payment, which is always a good thing. In addition to that, you could also rent out items or things you own in order to get a bit more cash.
What is a rent-to-own home? Find out here.
Pick Up a Second Job or Get a Higher Paying Main Job
Raising your income is one of the best ways to lower your DTI ratio. Of course, the first thing you could do is approach your boss about a raise. If they are unwilling, you can either look to get a job that is higher paying or simply find a second job to supplement your income.
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Look At Making Some Money Online
If you can’t or don’t want to find a new job, or you can’t get a raise at your current one, you can look into making money online. Sure, most of the time it won’t be life changing money you’re making, but it can help increase your income a little. With the internet and technology always improving, there are more and more opportunities to make money right from your home, with simply a computer or smartphone. You can do remote web design work, writing, complete surveys, become a virtual assistant, and so much more.
Pay Off Your Debt More Quickly
Of course, the more you put toward your debt, the quicker they will go away and the less time you will have that debt. So instead of paying the minimum or paying the same old monthly payment despite being able to afford more, you should look to pay them down as quick as you possibly can.While this isn’t always easy to do, especially if you have a low income, it can be helpful in reducing your DTI ratio soon.
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Take a Long Look at Your Expenses
Many of us have a lot of monthly expenses whether they are Netflix, a music streaming service, cable, etc. While some of these are essential, some of them are definitely not. If you hardly use a subscription or service, cut that expense and either put the extra toward paying down debt or bumping up your savings.
Check out our guide to automatic savings and automatic payments.
Look at Selling Your Car and Getting a Cheaper One
Besides a mortgage payment, a car loan payment is one of the biggest contributors to a high DTI ratio. Instead of continuing to pay a car loan you might not be able to afford, you could look into selling your car and getting something cheaper. This would lower your car payment each month most likely, which will in turn quickly and easily drop your debt-to-income ratio.
Read this for some ways of avoiding car loan debt.
In conclusion, knowing and understanding your debt-to-income ratio can be helpful when it comes to understanding how much debt you truly have. Furthermore, it is an important measure that lenders use to see how you can manage debt. While it might always not be easy to improve your debt-to-income ratio, it can definitely be done with a little bit of hard work and dedication to improving your financial health. Hopefully, this article helped you to understand what a DTI ratio is, how to calculate it, and how to improve yours.
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