With the everchanging financial market scenario, it is evident that you may want to apply for credit whenever necessary. While searching for a suitable credit option or checking whether you will qualify for a loan or not, you might come across the term- debt-to-income ratio from specific financial experts.
What is the Debt-to-income Ratio?
As the name suggests, Debt-to-income (DTI) ratio is the percentage of your monthly gross income used to pay your debts. This ratio can help in determining your borrowing risk. Moreover, it also affects your credit score and interest rates, among other factors. It may also include your principal, taxes, fees, and insurance premiums.
The debt-to-income ratio clearly shows how much your income is taken for debt repayment and is always expressed in percentages.
What is the importance of the Debt-to-income Ratio?
The Debt-to-income Ratio may serve as an essential factor in determining your credit history. According to the Consumer Financial Protection Bureau (CFPB), the DTI is one of the most significant ways of looking at your total financial health. It also states that a high DTI can result in the termination of any additional credit or loan or rejection of any new credit/loan application. If your DTI is high, it will hamper your loan application process.
The Debt-to-income Ratio is a significant factor taken into consideration by money lenders to determine your borrowing risk and the likelihood of repaying on time. It emphasizes your financial management skills.
What is considered a good debt-to-income ratio?
There are various factors on which your unique DTI will depend. However, the Consumer Financial Protection Bureau (CFPB) has issued some guidelines that help determine the same. They are:
- For anyone who owns a house, the debt-to-income ratio should be at 36% or less. It should include all your mortgage payments and debt. It will also include the funds that have been gathered by using a line of credit. The highest DTI that homeowners can have is up to 43%. Only then can you qualify for a loan application.
- For any renters, the debt-to-income ratio should be somewhere between 15-20% or less. It is noteworthy that your rent is considered while calculating your DTI.
You should speak with a financial advisor or counselor if you still struggle with keeping your debt-to-income ratio in check.
How to calculate your Debt-to-income Ratio?
Finding your debt-to-income ratio may look complicated on the outside, but it can be done easily if you follow the instructions mentioned below:
- Add your total debt
The first and foremost step includes the addition of the total debt that you pay monthly. This may include student loans, home loans, credit card payments, and automobile loans. Additionally, if you have impending alimony, it will also be counted.
- Get an idea about your overall monthly income
The next step includes the calculation of your monthly payments. This consists of the overall payment before you pay your taxes, insurance, and others. If you have a varying income, try making the closest estimate.
- Divide the two
The last step is simple. Once you have all the information you’ll need about your monthly income and debt, it is recommended to divide the two. Divide your debt with your income. That’s your debt-to-income ratio. Multiply your answer by 100 to get the total percentage of your debt-to-income ratio.
Debt-to-income ratio plays an important role when you apply for a new credit card or loan. Lenders might determine whether they will offer you the credit you have applied for, after considering your DTI. That’s why it is recommended to keep your DTI in check. You can do that by having a reasonable estimate of your income. If it isn’t adequate, it is time to look for a job with increased pay.