Recently, I had a conversation with a friend who was trying to refinance her home. Two different lenders denied her because her debt-to-income ratio, or DTI, was too high. My friend was frustrated and asked me why this happened and what her debt-to-income ratio actually was. More importantly, she wanted to know how to reduce her debt-to-income ratio.
What’s Ahead:
Your debt-to-income ratio, explained
Your debt-to-income ratio is a personal finance measurement that compares your debt to your income and is used together with other indicators to determine your creditworthiness (particularly when buying a house).
Your debt-to-income ratio is calculated by dividing your total monthly debt payments by your gross monthly income, and is written as a percentage.
Example: Let’s say my friend’s total recurring monthly debt payments were composed of:
- $1,000 housing payment (including mortgage, PMI, and taxes)
- $600 car payment
- $200 car payment
- $220 credit card payment
- $350 student loan payment
for a grand total of a $2,370 in monthly debt payments. Let’s also say her gross monthly income is $4,000. This means her debt-to-income ratio would be $2,370/$4,000, or 59 percent.
A debt-to-income ratio of 59 percent is high, and my friend would have a hard time getting a loan (or refinancing) without changing something.
Calculate your debt-to-income ratio:
How to change your debt-to-income ratio
You can improve your debt-to-income ratio in three ways:
- increase your income
- pay off debts
- refinance existing debt with a lower monthly payment
Increasing income
Increasing your income affects the ratio like this:
Example: If my friend had the same amount of debt ($2,370) but a gross income of $8,000 per month, then her debt-to-income ratio would be 29 percent ($2,370/$8,000=0.29625).
Paying off debts
The second way to improve your debt-to-income ratio is to decrease your debt. If my friend paid off one of her car loans, then she would have less debt and a better ratio.
But here’s the catch: DTI is based on your monthly debt payments, not the total amount of the debt. That means if you make extra payments on an auto loan, for example, you are reducing the outstanding balance but your monthly payments stay the same … and so does your debt-to-income ratio.
If you have high credit card balances, making additional payments will improve your debt-to-income ratio because the minimum monthly credit card payments are calculated as a percentage of the outstanding balance
Conversely, if you increase your debt or decrease your income, your ratio is going to be higher.
Refinancing
You may be able to reduce your student loan payments by refinancing at a lower interest rate or by increasing the number of years over which you repay the loan. While a lower interest rate is a good thing, we don’t recommend refinancing to extend the amount of time it will take you to pay off a debt.
Ironically, however, this move might enable you to get approved for a mortgage when you otherwise couldn’t. Again, it’s because the lending bank only cares about monthly cash flow, not overall debt.
Related: Buying a home, even if you have big student loans
The takeaway
Regardless of whether it is high or low, there is value in knowing your debt-to-income ratio. If your ratio is high, it can take some time to decrease it. The sooner you know, the sooner you can implement a plan. If your ratio is low, this means you should have an easier time getting approved for a mortgage or a refinance. Either way, there is power in knowing.