Understanding Debt-to-Income Ratio and Its Importance

Published by Programme B

One of the signs of a healthy financial life is keeping your debt-to-income (DTI) ratio at or below 43%. According to CTV News, Canada’s ratio when it comes to household debt and disposable income is high in the fourth quarter. It means that disposable income dropped and borrowing increased.

Aside from your credit history, lenders will look at your debt-to-income ratio to determine the risk associated with you borrowing money. Thus, it’s necessary to keep your DTI ratio under control.

Learn from this blog post what is a debt-to-income ratio, how to calculate it, and other things you need to know about it.

What is Debt-to-Income Ratio?

A debt-to-income ratio compares your monthly gross income to your monthly debt payments. A percentage of your disposable income that you pay for your monthly debt obligations, such as your car loan or mortgage, refers to your debt-to-income ratio. Based on this metric, lenders will know how much debt you can afford to borrow.

How to Calculate Your Debt-to-Income Ratio?

Calculating your debt-to-income ratio is easy. You only need to add up the total debt payments you’re paying every month. Types of debt you can include in the calculation are the following:

Any types of loan, including student loan, auto loan, and personal loan
Minimum payments of credit cards
Housing, including mortgage payments plus interest, rent, home insurance, property taxes, and homeowners’ association fees
Child support and alimony

Then, know your monthly gross income (your income before any deductions and taxes). To get your debt-to-income ratio divide your monthly debt obligations by your monthly gross income. If you have an $8,000 gross income per month and you’re paying monthly debt payments of $2,800, your debt-to-income ratio is 35%.

What is a Healthy Debt-to-Income Ratio?

The preferred debt-to-income ratio varies by lender and loan product. For instance, most mortgage lenders typically have a maximum DTI ratio at 36%, while some lending companies consider a maximum of up to 43%. Your goal is to keep your DTI ratio at this level or lower.

Does Debt-to-Income Ratio Impact Credit Score?

No, your DTI doesn’t directly affect your credit rating. There are different factors that make up your credit score, and debt-to-income ratio isn’t one of them. However, some components that contribute to your DTI can impact your credit. For example, the amount of debt you owe can affect your DTI and credit rating.

Is Debt-to-Income Ratio and Debt-to-Limit Ratio the Same?

Many people confuse debt-to-income to debt-to-limit ratio. While it’s true that many lenders use both metrics to determine a person’s borrowing risk, these two metrics are different from each other.

The debt-to-limit ratio, also known as credit utilization ratio, refers to the total available credit you’re currently using. According to this metric, you should keep your credit card balances below 30% of your credit limit. Aside from your payment history, your debt-to-limit ratio is a significant component of your credit score.

If you want to borrow money, you should ensure that both your debt-to-income ratio and debt-to-limit ratio are low.

What are the Ways to Lower Debt-to-Income Ratio?

Having a debt-to-income ratio higher than 43% doesn’t bode well for your borrowing capacity. If you see yourself in this unfortunate situation, you should take note of these ways to lower your DTI ratio.

Create a plan to pay off your credit card debts.
Make extra payments or raise the amount you pay for your monthly debt to lower your total debt faster.
Ask your creditors whether they can lower their interest rates, which can help you save money to pay off your debt obligations.
Don’t add more debt to your existing debts.
Take some steps to raise your income.
Review your debt-to-income ratio every month and discover if the above-mentioned suggestions help lower your DTI ratio.

Takeaway

Taking care of financial matters is important. If you want to take any type of loan, you have to know your debt-to-income ratio. Lenders use this metric to assess your borrowing risk. The lower your DTI ratio, the more chances you can borrow money. If you have a DTI ratio higher than 43%, make sure to follow the steps mentioned in this article to lower it.