When lenders evaluate your application for a loan, they are trying to assess your ability to repay the loan on a long-term basis. One important indicator lenders use to determine this is your debt-to-income ratio, a metric that shows how much of your current monthly income will go to paying off debts.
The level of importance this plays depends on the type of loan: Smaller loans may not emphasize it as much, but it will likely be very important to mortgage lenders, as they want to ensure a loan won’t stretch your finances too far.
Luckily, calculating your debt-to-income ratio is fairly simple.
What Is My Debt-to-Income Ratio?
To figure out your debt-to-income ratio, simply add up all your monthly debt payments and divide that sum by your gross monthly income.
What sort of debts are we talking about? Well, the monthly debt payments you’ll want to note include housing costs and debts that would be included on your credit report, such as credit card payments (use the minimum payment as your guide), student loans and auto loans. Monthly expenses such as utilities, groceries or gas generally don’t count. Your gross monthly income is the amount you make before taxes and deductions are factored in.
Let’s make this debt-to-income ratio formula a bit easier to understand. Say you have a $2,000 monthly mortgage payment, a $300 monthly car loan and a $200 monthly student loan payment. Based on that information, your total monthly debt would equal $2,500. From there, you’d take a look at your income, which we’ll say is $60,000 annually, or $5,000 before taxes and other deductions. That would make your debt-to-income ratio 50% (2,500/5,000 = .5, or 50%).
Why Is My Debt-to-Income Ratio Important?
Lenders assume that applicants with a high debt-to-income ratio will have more trouble repaying their loans and applicants with low debt-to-income ratios will be less risky. The lower your debt-to-income ratio, the greater the chance your loan application will be approved.
What Is a Good Debt-to-Income Ratio?
Standards can vary according to lenders. According to Wells Fargo, they consider a debt-to-income ratio of 35% or lower favorable, while a range of 36% to 49% could use improvement and 50% or more limits your ability to borrow.
In addition, having a debt-to-income ratio above 43% can prevent you from landing a Qualified Mortgage. Qualified Mortgages protect you from harmful loan features like balloon payments, negative amortization and interest-only repayment periods. They also limit the amount of upfront fees your lender can charge you. If you want to own your own home, it could be in your best interest to stay far away from the 43% threshold.
How Do I Improve My Debt-to-Income Ratio?
You can improve your debt-to-income ratio in two ways: reducing your debt or increasing your income. Of course, doing both would make the biggest difference.
You can pay down your debt by making your payments on time (avoiding late fees) and in full instead of only making the minimum payment and tacking on interest charges. Paying more than the minimum payment on your loans will help you get faster results. (You can see how your debt is affecting your credit by viewing two of your free credit scores on Credit.com.)
In terms of increasing your income, the most obvious way is to ask for a raise at your current job. If that’s not an option, you can take on side gigs to increase the money coming in or even consider applying for a new job and negotiating a higher salary.
What Is Considered a Monthly Debt?
As we mentioned earlier, monthly debts include housing costs, the minimum monthly payment on your credit card, student loans, auto loans and any other possible debts that are reported on your credit report. In most cases, your other monthly bills (like what you pay to fill your gas tank or your streaming subscription) won’t be included.
How Do I Catch Up on My Debt Payments?
Obviously, getting a raise and using that additional income is a good solution. However, that’s not always an option, so there are other things you can do. Consider combing through your budget and finding ways to adjust it. You can also reference this guide of 50 ways to help you cut back on debt.
Another option if you’re in over your head and struggling to make bill payments is to talk with a counseling agency or debt management company. These may be able to help you with a debt management plan. If you’re getting calls from debt collectors, you may want to try and negotiate the removal of the debt from your credit report upon payment.
Want to know more about how your debt-to-income ratio affects you? Leave your questions in the comments and one of our experts will try to help.
This article has been updated. It was originally published January 17, 2017.