Whether you’re considering a new line of credit 💰 or dream of owning your own home one day 🏡 there are two measurements you need to know: your credit score and your debt-to-income (DTI) ratio.
Most people are familiar with the concept of a credit score, even though you may not know exactly what’s in it. As a quick recap, your credit score will vary depending on the type of credit score and credit scoring model. For example, Truebill reports your Vantage 3.0 credit score, while your bank may use the FICO credit score model.
Both models use similar factors to determine your score, though they may be weighted differently. As we covered earlier in financial literacy month, payment history is the top-weighted factor regardless of the scoring model. You can get the details on what’s included in your credit score here.
But what about your DTI ratio?
What is a DTI ratio? 🤔
Your DTI ratio is another measure of your financial health, one that credit and mortgage lenders in particular look at when deciding whether to approve you for a mortgage calculation. At a high-level, your DTI ratio is a measurement of how much monthly debt you have, compared to your monthly income.
How do I calculate my DTI ratio?➗
Your DTI is calculated as a percentage by taking all of your monthly debts and bills and dividing it by your gross monthly income (what you make before taxes and deductions). Below is a list of common debts and bills that might be included. You can also use a calculator like this one from Rocket Mortgage to calculate your DTI ratio automatically.
Debts commonly included in a DTI ratio:
- Rent or mortgage payments 🏡
- Auto payments
- Student loans 🧑🎓
- Persona loans
- Credit card payments 💳
- Other monthly debts
Why it's important 💰
Your DTI ratio is important because even if you have a strong credit score, if your DTI ratio is high, a lender may be less likely to approve or give you favorable terms on a credit application. While any credit application may consider your DTI, this is especially true for mortgage applications. In general, a mortgage lender will not approve your application if your DTI ratio is higher than 43%. This means that even if your credit score is high and you’ve always paid your payments on time, you can still be denied a mortgage if your DTI ratio implies that you couldn't handle an additional monthly debt.
Further, it is important to keep in mind that your DTI is designed to prevent you from a situation where you might struggle or be unable to meet your monthly debt. Beyond what a lender may decide, it is important to keep this in mind as a measure of your financial health to avoid situations that may put you at financial risk.
What DTI ratio do I want to aim for? ⬇️
Ideally, you want your DTI ratio to be lower than 36% across all of your debts, with no more than 28% of that going towards existing rent and/or mortgage payments. Below 36% and a lender will be more likely to approve your application with the best possible terms.
If your DTI is between 36% and 43%, you may still get approved for a qualified mortgage, though some lenders may be a bit more hesitant. A qualified mortgage means that a lender has decided you are “qualified” to repay the loan, and therefore can extend certain benefits and protections through a qualified mortgage.
Above 43% and it's unlikely that you'll be approved. If you are, that approval may involve a non-qualified mortgage with less favorable terms, depending on the lender, like a longer repayment period or “balloon payments” on a mortgage that require larger than normal payments towards the end of your repayment, for example.
How can I improve my DTI ratio? 🙌
If your DTI is high, you have two options to bring it down:
1️⃣ Decrease your debt – can you reduce or pay off a credit card bill, reduce your rent or mortgage payment (consider refinancing, for example), or accelerate your debt repayment using the Avalanche or Snowball method? A few options to decrease your debt might include:
- Consider refinancing your credit cards with Truebill’s partner, Happy Money
- Refinancing your student loans with Truebill’s partner, Credible
- Consider refinancing your mortgage with Rocket Mortgage to reduce your monthly payments
You’ll also want to avoid taking on any new debt, as putting additional items on your credit card would only increase your DTI ratio.
2️⃣ Increase your income – can you negotiate a raise or cost of living increase with your current employer or consider a part-time job to increase your income? Keep in mind DTI is calculated using your monthly gross income (before taxes or deductions) so decreasing any pre-tax contributions, like contributions to your 401k, won’t make a difference to your DTI ratio.
Regardless of what you decide, we hope this article is helpful in learning how to improve your DTI, and more importantly, how it's a helpful measure of financial health when considering a new line of credit.