Debt to Income Ratio: Top Indicator of Your Financial Health

debt to income ratio how it worksMany people don’t realize that debt-to-income (DTI) ratio is an important part of a person’s overall financial health. And because it’s important to keep track of your financial status, calculating the DTI may help determine if one’s comfortable with current debt load and if applying for additional credit is the right choice for them.

Why the Debt to Income Ratio is Important

When you apply for credit lenders review your DTI to decide if you can afford to take on more debt and an additional payment. The debt-to-income ratio is an important number to monitor. That’s because it tells you a lot about how precarious or stable your financial situation is. The debt-to-income ratio is an important measure of your overall financial security.

  • If your debt-to-income ratio is too high, any radical changes to your income could leave you with unmanageable levels of debt.
  • The lower your debt to income ratio is, the more affordable the debts you have are. With a low DTI, the easier you will be able to manage any financial hurdles that come your way.
  • Calculate Your Debt to Income Ratio?

    From the perspective of creditors and lenders, the DTI is an important measure that they use to assess risk. People with higher debt-to-income ratios are more likely to default on their debt.
    The debt-to-income ratio is a number that expresses the relationship between your total monthly debt and your gross monthly income. Please check out the formula below:

    Debt-to-Income Ratio = Total Monthly Debt Payments / Gross Monthly Income.

    What is a Good Debt to Income Ratio?

    If 43% is the maximum debt-to-income ratio you can have while still meeting the requirements for a debt, what counts as a good debt-to-income ratio for general purposes?

    Usually, the answer is a ratio at or below 36%. A DTI of 36% gives you more breathing room than a DTI of 43%, leaving you less vulnerable to a negative impact if changes in your income and expenses accordingly occur.

    Improving Your DTI

    In the instance where you’re applying for a particular loan, improving your debt-to-income ratio can make a huge difference in how lenders view you in terms of lending.

    Several steps can help you achieve a lower DTI, including:

    • Reduce your total debt by paying off credit cards and paying down any other loans that you are able to.
    • Avoid taking on new debt before applying for another one.
    • Consider a debt consolidation loan to make it easier to reduce debt faster if you are carrying large amounts of debt.
    • Increase your income by asking for a raise, getting a second job or finding a new primary job that has a higher pay rate.
    • Review your budget to see where you could save money to put toward paying down debt. If you don’t currently have a budget, create one.

    Link Between DTI and Credit Score

    Since income does not appear on your credit report and is not a factor in credit scoring, your DTI ratio doesn’t directly affect your credit report or credit scores accordingly.

    However, while your income is not reported to credit bureaus, the amount of debt you have is directly related to multiple factors that do affect your credit scores, including your credit utilization ratio. It’s best to keep your debt low from the get-go, than try to recover from a difficult situation. If your DIT is at the acceptable ratio then so many doors will be open to you!

    Excerpt: When it comes to approving a loan, lending institutions are very vigilant and use many instruments to check the borrowers’ profiles. Debt-to-income ratio is a top indicator in this sense. Learn how it works.