Your Debt-to-income ratio is used to determine whether you are a good candidate for a home loan. It is simply a measurement your monthly debts, relative to your monthly income, expressed as a percentage.
To work out your DTI ratio, add up all your monthly debts, divide the total by your monthly income, and then multiply that number by 100. You will be left with your DTI ratio. You can also use our simple calculator below.
What is a good debt-to-income ratio?
Simply put, the lower your DTI ratio the better. If your DTI ratio is low, it effectively means that you are a low-risk borrower, which makes your financial profile very attractive to banks and other lending institutions.
The guidelines below should give you more insight into what banks consider a good debt-to-income ratio to be:
- Less than 36% = Low Risk Borrower: If your DTI ratio is less than 36%, you should find that most banks will gladly give you a mortgage. Assuming your income is stable and you have no blemishes on your credit history, you should be able to shop around for the best possible interest rate.
- 36% to 42% = Moderate Risk Borrower: This is a relatively common bracket for people to fall into, and you have reason to be confident that many of your loan applications will be approved. Although people in this category have room for improvement, their risk profile is still considered moderate enough to be a safe bet for most banks.
- 43% to 50% = High Risk Borrower: In years past, it was very uncommon for people with a DTI ratio higher than 43% to be granted a home loan. However, it is now increasingly common for loans backed by Fannie Mae and Freddie Mac to accept a DTI ratio as high as 50%. While this certainly isn’t the ideal range to fall into, you still have a realistic chance of successfully acquiring mortgage, even if you are in the high-risk range.
- Higher than 50% = Non-Borrower: Once you move above the 50% DTI range, you will find it very difficult to secure a traditional mortgage. While there is nothing preventing you from applying, you are likely to be met with rejection by each and every lender that you approach. People in this category are basically walking red flags that banks will do their very best to avoid.
How To Calculate Debt to Income Ratio
DTI = (Total Monthly Debts / Gross Monthly Income) * 100
Examples of How To Calculate DTI
Example 1: Recently Graduated Student
- Income: $2200
- Rent: $750
- Car Repayment: $200
- Student Loan Repayment: $125
- Credit Card Repayment: $80
- DTI = ($750 + $200 + $125 + $80)/$2200 * 100
- DTI = 52.5%
Example 2: Recently Divorced Accountant
- Income: $9600
- Mortgage Repayment: $2,000
- Car Repayment: $400
- Child Support Payment: $500
- Credit Card Repayment: $100
- DTI = ($2000 + $400 + $500 + $100)/$9600 * 100
- DTI = 31.25%
What Expenses Are Factored into DTI Ratio?
- Monthly rent or mortgage repayment
- Monthly Student loan repayment
- Monthly car repayment
- Monthly credit card payment
- Monthly child support payments
- Any other monthly debt that you are currently paying
From the list above it should be plain to see that every debt payment that you currently have is factored into your DTI ratio. The only exception is rent, which is substituted for a mortgage repayment when assessing people that don’t own a home.
Other monthly expenses like grocery shopping, electricity, digital subscriptions, petrol and other regular expenses are excluded from your DTI calculation. In essence, there needs to be a loan associated with the expense in order for it to be classified as a debt. The only exceptions are rent and child support payments.
Is rent included in debt-to-income ratio?
Yes. If you are currently paying rent, the lender will factor your monthly rent payment into your debt-to-income profile.
In essence, when calculating DTI, either your monthly rent is factored into the equation, or your existing mortgage payment is factored into the equation. It’s literally one or the other. They are interchangeable variables, depending on the personal situation of the borrower.
How To Decrease Your Debt-to-Income Ratio
1) Create a budget: Creating a budget is one of the first recommendations of most personal finance experts, and for good reason. Having a better sense of your income, expenses and monthly cash flow will make it far easier to manage your money, and payoff any existing debts faster. As Dave Ramsey so famously quipped ‘a budget is telling your money where to go instead of wondering where it went.’
2) Consolidate your existing debts: If you already have a home loan, there’s a good chance you can reduce your total monthly debt repayments, by consolidating every loan into your mortgage.
Even if you don’t have a mortgage, there are lending institutions that can consolidate all your debt into one payment, which has three primary benefits:
Benefit 1: Single Repayment – A single repayment will can simplify the process of paying all your debts each month. It is less hassle and more manageable for most people.
Benefit 2: Lower Interest Rate – When done correctly, the overarching interest rate of your debt should decrease. This will automatically reduce your DTI ratio, and thereby increase your chances of being granted a loan.
Benefit 3: You can pay off your debt faster – The goal of most reputable debt consolidation agencies is to drastically reduce the amount of time it takes you to pay off your debts. Ideally, you should be aiming for something in the 3-to-5-year range.
3) Sell your car: A car loan is one of the few debts that you can eliminate within a matter of days if you decide to sell your car. This strategy is perfect for anyone that is paying off an expensive car that is ultimately handbraking their financial future. Paying off your car is a fast and reliable way to lower your DTI ratio, and you can always buy a more affordable car in the process if public transport is an issue in your area.
4) Increase your income: Another bankable way to increase your DTI ratio is to increase your income. This could mean negotiating a raise with your current company, switching to a new company that pays more, or starting a profitable side hustle. Each of these options can increase your total income and thereby lower your debt-to-income ratio.
5) The Debt Snowball Method: The debt snowball method was made popular by Dave Ramsay. To implement the debt snowball method, you identify all your debts, listing them from smallest to largest. The goal is to pay off the smallest debt first, then the second smallest debt, then the third smallest debt and so on. You then just repeat this process until the only debt left is your home loan.
One of the reasons the debt snowball method works well is because it can create a psychological feeling of victory and control over your debt. Each debt that you pay off acts as an important step toward being debt free, while opening up additional cash flow to tackle the next debt on your list. If you implement this strategy, it can create a powerful sense of momentum and dramatically increase your motivation eradicate all the remaining debts on your list.
6) The Debt Avalanche Method: The debt avalanche method is essentially just a variation of the debt snowball method. However, instead of tackling your smallest debt first, you tackle the debt with the highest interest rate. This approach can work very well if you have repayments with extremely high interest rates that are crippling your ability pay off your other debts.
What is the average debt-to-income ratio in America?
According to the economic research of the Federal Reserve Bank of St.Louis, the average household debt service payment as a percent of disposable income is 9.40% as of Q4 2020, in the US.
Calculating your DTI ratio is a good way to sense check whether or not you will be eligible for a mortgage. It is a relatively simple calculation that can help you evaluate your risk profile as a borrower, and it also pays a role in your credit score.
In an ideal world, you should aim to keep your DTI ratio below 36%, as this will give you the most flexibility when applying for home loans.