You know you love a good benchmark: a way to compare your progress to the gold-standard, or at the very least the progress of other people you know. It’s undoubtedly one of the reasons we all collectively went crazy about knowing our credit scores… except you probably got a bit too fanatical about your credit score. It’s far from the only indicator of your overall financial health. In fact, the other number you desperately need to know is probably one of which you’ve never even heard: debt-to-income ratio.
What is debt-to-income ratio?
Debt-to-income ratio, or more commonly DTI, is a calculation to determine how much debt you’re carrying relative to your income. Before you freak out — it’s not based on cumulative debt to annual income. If that were the case, student loans alone would put many people at over 100 percent debt. Instead, the calculation is based on your monthly debt obligations to income situation.
Who is likely to use your DTI?
Your DTI will come into play when you need to borrow money. That could be refinancing student loans, an auto loan, mortgage or personal loan. Lenders use your DTI to determine if you’re a worthy borrower and the maximum amount you could borrow given your other financial obligations. Sure, your credit score is also a factor used by lenders, but DTI provides a more comprehensive view of your financial ability. It gives lenders far more knowledge about just how much more debt you could feasibly handle each month.
A credit score really just provides a lender with a snapshot in time, and the credit score can be more volatile than DTI. One month where you accidentally miss a payment because you were traveling internationally and it slipped your mind can tank your credit score. And using more of your credit card limit than normal because it’s holiday shopping season or opening a new account because you’re trying to travel hack for free flights (and you will definitely pay off your credit card in full each month!) can ding your score. But your DTI isn’t going to fluctuate quite as easily because fewer factors influence the percentage. Lenders want to know as much as possible about you before giving you money. They want security that you’re reliable and will pay it back. So just one metric (the credit score) isn’t enough to convince them of your trustworthiness.
What is a good DTI?
Your DTI goal is the inverse of your credit score. You want a high number with a credit score, but the goal is a low debt-to-income ratio. Unfortunately, there isn’t a cut-and-dry answer to what is an ideal DTI because it does vary based on lender. However, the Consumer Financial Protection Bureau cites 43 percent as the highest ratio you can have and still be approved for a Qualified Mortgage. A general rule of thumb is to keep your DTI below 36 percent.
What can be done to improve your DTI?
There can be a two-pronged approach when trying to improve your DTI. First, you can focus on reducing your monthly debt obligations. Eliminating consumer debt, like credit cards, is a great way to start. Second, you can aim to increase your overall income while avoiding incurring any new debt. A higher gross monthly income with the same monthly debt burden automatically reduces your DTI. Reducing debt and increasing income really helps improve your DTI quickly.
Your DTI may not ever be something to get you loads of love on Instagram or retweeted hundreds of times, but it is one of the key ways you’ll be financially judged. Being aware of your DTI and aiming to keep reducing your overall debt burden should be a top priority as you move forward in your financial life.
How to find your DTI
You could do the basic calculation yourself: (required monthly debt payment) ÷ (gross monthly income) and then x 100 to equal the percentage. Or you could ditch doing the calculations yourself and use online tools. My new favorite (and free) tool is Turbo, from the makers of TurboTax. It will pull not only your DTI but also your credit score and verified income. With that information, Turbo gives you tips and advice on how to improve your financial life and feel empowered, so you never need to worry about whether or not lenders will find you alluring.
(Photo via Getty)