Your credit score is considered during the review process when you apply for a new credit card or loan. And sometimes your employer, auto or home insurance company, or a potential landlord will consider your credit. But another number that is often considered during the lending process is your debt-to-income (DTI) ratio.
How to calculate DTI.
Your DTI is a simple way to weigh how much of your income is put toward debt payments each month. Debt payments do not include monthly bills, like cell phone payments or streaming subscriptions because you can cancel these services at any time. You are, however, obligated to make payments each month to pay back any loans you took out.
To calculate your DTI, add up your monthly debt payments (mortgage, credit card payments, student loan payments, any other loan payments) and divide this number by your gross income (your pay before taxes, insurance, and other deductions are taken out).1 Then multiply this number by 100 to convert it to a percentage.
For example, if your debt payments each month total $1,000 and your gross income is $4,000, your DTI would be .25. When you multiply this by 100, you get a DTI of 25 percent.
Why is your DTI important?
Your debt can have a big impact on your overall financial wellbeing. Lenders (especially during the mortgage process) look at DTI to make sure you’re not taking on too much debt, as you still need money to save and spend on essentials each month.
As a general guideline, a good DTI is considered 43 percent or lower, although many lenders recommend maintaining a DTI under 36 percent (so your total loan payments should not be more than 36 percent of your gross income).2 Again, this guideline is to ensure you’re not taking on more debt than you can afford.
DTI and your small business.
Many entrepreneurs are surprised to learn that their personal DTI is considered during the business lending process, especially when applying for a small business microloan. When lenders see that you’re able to manage your personal loan payments, they may be less hesitant to extend credit to your business. So, if you’re considering funding options for your business, it may be a good idea to calculate your DTI before applying for a business loan.
The State of Michigan3 website offers many resources for small business owners who are starting a business, looking for assistance, need tax help, and more.
How to lower your DTI.
If your DTI is higher than the recommended amount of 43 percent or lower, it may be beneficial to take steps to lower your DTI before applying for a loan. To decrease your DTI, you need to increase your income and/or reduce the balance of your debts.2 Consider the following to meet this goal:
- Ask for a raise at work.
- Get a second job, part-time job, or side gig to make extra cash that you can put toward your debt.
- Host a garage sale or sell items on your favorite social media site, then use the extra cash in your budget to make additional loan payments.
- Refinance your loans and see if you can get a lower interest rate with lower monthly payments. Depending on the loan type, there may be closing costs involved, so consider these costs before pursuing a refinance.
- Consider a personal loan to consolidate multiple loans into one loan. This may make it easier to keep track of payments, lower your interest rate, or reduce your monthly payments.
If you’re having trouble making your loan payments, contact the organization or financial institution that services your loan and ask about lowering your payment. Your creditors may offer payment plans or other options that work better with your budget.
Lake Trust members also have access to resources from our partners at Greenpath™ Financial Wellness3. The specialists at Greenpath™ can help you create a debt repayment plan, review your credit, or offer debt counseling services.
Your wellbeing, in your hands.
Your debt-to-income ratio is another important number in your financial toolbox. This simple formula doesn’t just prove to lenders that you know how to manage debt; it can also help you understand how debt is impacting your budget. If your DTI is too high, it might be time to create a debt repayment plan. And if your DTI is below the recommended limit, then it may be safe for you to take on additional debt as needed.
Remember, you’re not on your financial journey alone. We’re here to help you manage your debt and find solutions that align with your goals.
1Consumer Financial Protection Bureau. (2023, August 28). What is a debt-to-income ratio? Retrieved from https://www.consumerfinance.gov/ask-cfpb/what-is-a-debt-to-income-ratio-en-1791/#:~:text=Your%20debt%2Dto%2Dincome%20ratio,money%20you%20plan%20to%20borrow
2Folger, L. (2023, May 7). What Constitutes a Good Debt-to-Income (DTI) Ratio? Investopedia. Retrieved from https://www.investopedia.com/ask/answers/081214/whats-considered-be-good-debttoincome-dti-ratio.asp#toc-dti-and-credit-score
3Third party website. Lake Trust Credit Union is not responsible for the content, availability, security or compliance of any linked third party websites. In addition, the site's privacy policies may differ from those of Lake Trust.