It’s funny how our financial realities can seem to take on a whole new meaning when lenders get involved. For example, when you think about your student loans, you might think about a monthly bill or how many years you have left to pay them off. But when a lender looks at them, they might include them in a calculation to determine if you can afford to take on more debt. Same thing, different meanings.
This example points to something called a “debt-to-income ratio,” and it can play a part in whether or not you’re approved for new credit. Read on to learn what the debt-to-income ratio is, how you can calculate yours, and what the industry standards are for a “good” ratio.
What Is A Debt-to-Income Ratio (DTI)?
Put simply, your debt-to-income ratio (or DTI) is how much you owe each month on debt compared to how much you earn each month before taxes. Although your DTI doesn’t factor into your credit scores, it can sometimes factor into a lender’s decision to approve your credit application. For them, it can help show your current debt level and whether or not it seems realistic that you can handle more. There are two ways to look at this ratio:
- Front-End Ratio: Also called the “housing ratio,” it’s comprised of your housing costs compared to your monthly gross income (housing costs could mean mortgage payments, mortgage insurance, property taxes, HOA fees, and so on)
- Back-End Ratio: Your total debt compared to your monthly gross income
If this all feels a bit familiar, it might be easy to confuse your DTI with your credit utilization ratio. Your credit utilization ratio is the amount of revolving debt you owe (such as your credit cards or lines of credit) compared to your total credit limits. Installment loans (such as a mortgage or auto loan) do not factor into your credit utilization ratio. And, while your DTI doesn’t factor into your credit scores, your credit utilization does.
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How to Calculate Your Debt-to-Income Ratio
It can be fairly simple to calculate your DTI. All you have to do is add up all your monthly debts and divide them by your monthly gross (pre-tax) income.
As you think about what goes into your monthly debts, keep in mind that some non-debt items can come into play too, such as property taxes, child support payments, mortgage insurance payments if you have them, and so on.
Here’s what you can do if you want to get even more specific:
- To calculate your front-end DTI: Add up all of your housing expenses, divide that total by your monthly gross income, and multiply that by 100
- To calculate your back-end DTI: Add up all of your monthly debt payments, divide that total by your monthly gross income, and multiply that by 100
Once you know the amount you owe each month compared to how much money you take home before taxes, then you’ll have a better understanding of your ratio. Multiply the sum by 100, and then you have the percentage that reflects your DTI and what lenders might look at to determine if they think you can afford more debt.
Industry Standards for DTI and Lending
So, what’s a good debt-to-income ratio to have if you’re applying for new credit? It depends.
Not a lot of lenders share their ideal DTI for lending, so consumers are left to see what experts in the field are saying. One of the few that do share their rule, Wells Fargo, created a chart highlighting 35 percent or below as ideal.
Besides knowing exactly what your prospective lender is looking for, there are a few other pieces of advice that may help depending on your financial situation, such as the 28/36 rule. This rule dictates spending no more than 28 percent of your monthly gross income on your housing costs and no more than 36 percent on all of your debt. In other words, if you decide that keeping to this rule would be best for you, you would maintain a front-end DTI of 28 percent or less and a back-end DTI of 36 percent or less.
A more common number widespread throughout the industry, however, is 43 percent. If you think that figure works better for you, that would mean keeping your entire DTI at or below 43 percent, as explained in this article by the Consumer Financial Protection Bureau. But even that number has been changing.
According to the Washington Post, two years ago leading mortgage financer Fannie Mae increased their own maximum DTI standards from 45 percent to 50 percent. Per the Washington Post:
“That doesn’t mean everybody with a DTI higher than 45 percent is going to get approved under the new policy. As an applicant, you’ll still need to be vetted by Fannie’s automated underwriting system, which examines the totality of your application, including the down payment, your income, credit scores, loan-to-value ratio and a slew of other indexes. The system weighs the good and the not-so-good in your application, and then decides whether you meet the company’s standards.”
All in all, like the credit utilization ratio, the lower your DTI, the better your chances of being approved for new credit. Whether you’re aiming for the 28/36 rule or a maximum of 50 percent, lenders often feel more comfortable seeing a lower debt burden compared to income.
[Learn how to keep your debt from negatively impacting your credit – read this.]