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What is Debt-To-Income Ratio?

Why Is It Important?

Represented as a percentage, the monthly gross earnings that go towards paying debt is your debt-to-income ratio or DTI. This calculation is essential in personal finance because it helps lenders determine how much they’re willing to loan you.

The emotional and physical trauma caused by being in debt can be downright dangerous for your health. Therefore, getting a handle on your DTI is essential because it will help you make better financial decisions and improve your overall well-being.

Understanding what debt-to-income ratio is, how to calculate it, and what steps to take to improve it are critical for financial success and the freedom that comes with it. So, check out our DTI guide and get started on your path to becoming debt-free!

How is debt-to-income ratio calculated?

Debt-to-income ratio is calculated by dividing your monthly debt obligations by your gross monthly income. This number is then expressed as a percentage.Although it sounds complicated, it’s actually simpler than you’d think.

Let’s say you make $4,000 a month, and your monthly debts are as follows:

  • $900 for rent (your housing costs are always considered when calculating your DTI)
  • $500 for auto loan payments
  • $150 for credit card payments
  • $250 for student loan payments

Your total monthly debt would be $1,800. To calculate your DTI, you would divide $1,800 by $4,000. On a calculator, this will give you a decimal number: .45. To convert that to a percentage, move the decimal point over to the right two places; that gives you 45%.

What is a good debt-to-income ratio?

What qualifies as a good debt-to-income ratio will depend on the loan or credit line you are applying for. Generally, anything below 43% is considered to be a good debt-to-income ratio. However, a DTI of 36% or less is ideal for some loans, such as mortgages.

And while we’re speaking of mortgages: When you apply for a loan to buy your dream home, lenders will focus more on your DTI than on your credit score. That means that you can have a low DTI and a fair credit score and likely still qualify for the mortgage. But you cannot qualify with the reverse: a high DTI and a good credit score.

Throughout life, your debt-to-income ratio will naturally fluctuate. For example, when you are just finishing school and can only secure entry-level employment, your DTI will be higher than when you are further along in your career and earning a larger salary.

So, even if you have a good debt-to-income ratio now, that doesn’t mean it will always be this way — and vice versa. The trick is to be aware of your number and take proactive steps to ensure that it stays at a manageable level.

What are the dangers of having a high debt-to-income ratio?

Just because your debt-to-income ratio is lower than 43% does not mean you are in the clear. A high debt-to-income ratio can still present challenges.

You may be denied loans or lines of credit.

High DTI ratios raise a red flag for lenders because it indicates that, at the very least, you are using a large portion of your income to pay off debt. That leaves less room for other financial obligations, such as making your loan payments on time. As a result, a high DTI ratio can sometimes be the difference between being approved or denied for a loan.

You may have difficulty making ends meet each month.

A high debt-to-income ratio can further compound your financial difficulties if you are already struggling to make your minimum monthly payments. This is because you will have even less money available each month to cover your living expenses, which can quickly lead to financial hardship.

Your credit score may suffer.

Your credit score will likely take a hit as your debt grows. Although your DTI itself does not influence your credit score, your credit utilization does. How much of your available credit you’ve used, and how much total debt you’ve accrued, impact about 30% of your score. A low credit score can make qualifying for loans, lines of credit, and even jobs challenging. It can also lead to higher interest rates – which means you’ll pay even more in the long run.

What steps can you take to improve your debt-to-income ratio?

Have a high debt-to-income ratio? Don’t worry – there are ways to improve it. However, be aware that there is no “quick fix” when it comes to reducing your DTI. It will take time and effort, but it is definitely possible to get your debt-to-income ratio under control.

Start by evaluating your current financial situation. Take a close look at your income and expenses to get an idea of where your money is going each month. Are there any areas where you can cut back? For example, could you reduce your monthly expenses by eating out less often or cutting back on your cable bill?

Next, focus on paying down your debt. If you have multiple debts, list them from smallest to largest. Then, start chipping away at the smaller debts first. As you pay off each debt, you’ll free up more money each month to put toward the next one – and so on.

Finally, make a budget and stick to it. Once you have a clear idea of your income and expenses, it will be easier to create a budget that works for you. Be sure to include a “buffer” in your budget for unexpected expenses.

Debt Experts on Your Side

Lost the ability to keep up with your monthly payments? Are you struggling to make ends meet each month? Our team of experts is here to help. Debt settlement solutions from Reduction Financial offer a way out of the debt cycle — and get your debt-to-income ratio under control.

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