Why Your Debt-To-Income Ratio Is Important When Applying for Loans
If you’re looking to borrow money with the help of a loan, you may have heard the term “debt-to-income ratio” thrown around. Commonly referred to as DTI, your debt-to-income ratio is the debt you carry divided by your income.
Your DTI is an essential part of your overall financial health. When you apply for a loan, lenders evaluate your DTI to determine if it’s risky for you to take on another payment.
You might ask yourself, “What’s considered a good DTI?” or “What if mine is too high?”
Throughout this article, we’ll break down everything you need to know about DTI so that when you apply for a loan, your DTI is where it needs to be.
Let’s get started.
What is DTI and how is it calculated?
When you apply for a loan, a lender will consider several factors when determining approval. These factors include, but are not limited to, your credit score and history, income, employment history, and DTI.
In the simplest terms, DTI compares your monthly debt payments to your monthly gross income. Your monthly debt payments might include your mortgage, student loan, auto payment, alimony or support payments, and credit card bills.
Let’s say you have a gross monthly income (“gross” being the amount of money you make before taxes are deducted) of $7,000. To calculate your DTI, you need to add up your monthly debt payments. In this example, you pay $1,200/mo for your mortgage, $200/mo for your credit card balance, $400/mo for your student loan, and $400/mo for your car payment.
In this example, your monthly debt payments equal $2,200.
To determine your DTI, you would divide $2,200 by $7,000 (debt payments divided by gross income). This gets us approximately 0.31. When we turn this decimal into a percent, we get 31%. In this example, you have a 31% DTI ratio.
Want to see what your DTI ratio is? Use our handy DTI Ratio Calculator to crunch some numbers.
It’s also important to remember that the type of loan you’re applying for matters when calculating DTI.
For example, suppose you’re a renter applying for a mortgage. In that case, the lender will consider your estimated mortgage payment in their DTI calculation, but not your current rent payment (as you would no longer have that expense once you leave the rental). However, if you were to apply for a personal loan, the lender would include rent in the calculation, as it’s considered an ongoing monthly expense.
Why is DTI important?
When you apply for a loan, a lender will evaluate your ability to repay it. They will use your DTI as part of their risk calculation. If too much of your income is earmarked for debts you already carry, the lender will likely see it as a risk to lend you additional money.
In other words, the lender needs to be confident that you can repay your loan and still have cash left over each month to cover your other living expenses.
A lower DTI typically increases the chance of your loan application being approved. A higher DTI doesn’t necessarily mean you won’t get approved. However, it could result in a higher interest rate on your loan. It could also impact the loan amount the lender is willing to approve you for.
What is a “good” DTI?
There isn’t a one-size-fits-all “good” DTI percentage. Lenders can set maximums for their loan products, while some loans have specific requirements.
Here’s a basic rule of thumb, however:
- 36% DTI or lower = Excellent
- 37 – 43% = Good (43% is the maximum allowable DTI for Connexus Mortgage and Home Equity Loans)
- 44 – 45% = Acceptable
A DTI near 50% is the maximum for most lenders and loan products. Some loan products may be available at 50% DTI; however, approval will depend on other factors, such as a good credit score.
How can I lower my DTI?
If you want to borrow money but are concerned your DTI is too high, here are some steps to lower it before applying.
Create a budget. Track your monthly payments and expenses by creating a budget. Reduce or eliminate any unnecessary purchases to allocate more money toward paying down your debt.
Lower your monthly debt payments. Remember, DTI is looking at monthly payment amounts — not total debt. Therefore, debt consolidation can be a smart option as it could help lower your monthly payments.
Repay outstanding debts before applying. Try to minimize credit card usage, but continue making payments and aim to pay more than the minimum each month, if possible. When your finances allow, put a little extra cash toward the principal of any loans or credit card balances.
Consider refinancing. If you have a car or home loan, explore refinancing options that could help lower your monthly payment. At Connexus, our Auto and Mortgage Refinancing options offer low rates and affordable monthly payments.
Next steps
Now that you know what DTI is and how it impacts the loan process, you can take the necessary steps forward. Whether you need to improve your DTI before applying or are ready to hit the submit button on your application, we’re here to help.
Explore our affordable loan options and competitive low rates today. When you find a loan that fits your needs, you can schedule a call with one of our lending specialists, who will be happy to answer any questions and help you start the process.