By Jamie Wagner, Ph.D.
What is Debt to Income Ratio (DTI)?
Debt to income ratio (DTI) is the ratio of the amount of debt you owe compared to your gross income. Or, to put it in slightly different terms, the ratio is a comparison of all of the debt you have compared to your income before any taxes or deductions are taken out.
Types of debt include (but are not limited to):
- Mortgage (or rent) payment
- Car payment
- Minimum credit card payment
- Child support payment
- Personal loans
DTI Ratio Example
Suppose you pay $1,500 for your mortgage, $300 for your car payment and $100 minimum on your credit cards, and your monthly gross income is $4,000. Your DTI ratio is 47 percent which for most lenders is dangerously high.
What is DTI Ratio Used For?
DTI ratio is used by lenders as part of your financial story. In addition to your credit score which details some of your money and credit habits as well as history, the DTI ratio provides a snapshot of where you currently stand. Neither credit score nor DTI tell the complete story. Both must be considered to truly understand a person’s financial capabilities.
Preferred DTI Ratio
Many lenders suggest having a DTI ratio of 20 percent or less meaning owing less than 20 percent of your monthly paycheck before taxes and deductions are taken out. This is especially important because your net income is much different and lower than your gross income. Your debt to take-home pay is higher than your DTI.
Having a lower DTI ratio (20 percent or less) is a signal to the lender that you are not paying so much of your income to other debt that you cannot pay for a loan. For example, mortgage lenders want to make sure you have enough money each month to pay for your mortgage. Foreclosures are not only bad for the borrower, they are also bad for banks and credit unions, and therefore they should be avoided at all costs. The first step is to make sure the lender is loaning money to someone who is likely to pay it back.
Lenders are concerned for households with DTI ratios of 40 percent of higher. To put that in perspective, households with DTI ratios of 40 percent pay 40 cents of every dollar to some sort of debt payment (mortgage, car payment, credit cards, etc.). This leaves only a small fraction of your money (60 cents of every dollar) to buy groceries, gas, cell phones, daycare, utilities and other household necessities. DTI ratios this high can lead to other serious consequences, like bankruptcy, if the issue persists.
While lenders use this ratio and your credit score to determine whether they should lend you money, a high (or low) DTI ratio does not negatively (or positively) impact your credit score. These two pieces of information are fairly independent. Credit bureaus can be aware of your income but cannot report it. The credit score is more of a history of your payments and credit habits.
What You Can Do to Lower or Control Your DTI Ratio
There are two major ways to lower your DTI ratio. The first is to lower your debt. Some ways to lower your debt include:
- Controlling your credit card spending
- Taking out a personal loan for only the amount that you need
- Buying a less expensive car
The second way is to increase your income. This might include taking on a second/part-time job or selling items that you no longer need.
If you have continued concerns about your DTI ratio and how it could impact your borrowing, please seek out a Centris service representative to set up an appointment and formulate a plan.
