What Is a Debt-to-Income Ratio?
If you are thinking about applying for a loan, you may have encountered the term debt-to-income (DTI) ratio while researching your options. When considering applicants for a loan, lenders evaluate this ratio to make sure borrowers don’t have too much debt.
Understanding the DTI ratio and how it works can help assess your ability to qualify for a loan. If your DTI ratio is high, there are some things you can do to lower it to improve your chances.
Debt-to-Income Ratio Defined
The DTI ratio is a simple ratio that compares your current income to how much debt you have. It’s very easy to calculate. You simply add up all of your monthly debts and then divide them by your current income. The DTI ratio is always expressed as a percentage, and lenders prefer to see DTI ratios of 36% or less.
If a loan applicant has a high DTI ratio, that person may have too much debt. It could mean that the applicant may default on one or more debts at some point.
Lenders consider a variety of factors when evaluating you for a loan including your credit score, employment history, and others. Having a high DTI ratio may not automatically disqualify you for a loan, but it could result in a higher interest rate if you are approved. If you have a low DTI ratio and a good credit score, however, you could get a lower interest rate and save money.
A Practical Example
Consider the following hypothetical example to see how easy it is to calculate the DTI ratio.
Let’s assume that you have the following monthly debts:
- Mortgage: $1,250
- Car loan payment: $500
- Student loan payment: $350
- Credit card payments: $150
- Personal loan payment: $250
When totaled, your monthly debt payments are $2,500.
It’s important to point out that you only need to include those things that you are financing. You don’t have to include your living expenses. Expenses such as groceries, utilities, and insurance are not considered debts.
The next step is to add up all of your monthly income streams. Continuing with our hypothetical example, let’s assume you have the following monthly income:
- Rental income: $800
- Investment income: $600
- Employment income: $6,000
Your total monthly income is $7,400.
The last step in determining your DTI ratio is to divide your total monthly debts by your total monthly income.
$2,500 / $7,400 = 0.337
DTI Ratio = 34%
How Do You Lower Your DTI Ratio?
If you discover that your DTI ratio is currently higher than the 36% threshold that lenders prefer, there are several things you can do to lower it. You will then be in a more favorable position to apply for a loan.
Earn More Money
This is easier said than done for many, but earning more money will improve your DTI ratio. Two possibilities are working more hours at your current job or working a side hustle in your spare time like mowing lawns, giving music lessons, being a rideshare driver, or something else.
Pay Off Debts
Paying off one or more of your current debts is another way to lower your DTI ratio. While it may not be possible to pay off a large debt—like your mortgage or car payment—you may be able to pay off your credit cards. This will also help you save money on the high interest that credit cards charge.
Control Non-Essential Spending
Avoiding the temptation to add to your debt is important while you are working to improve your DTI ratio. It’s difficult to pay down your credit cards, for example, if you continue to add to your debt with non-essential purchases.
Consolidate Debt
If you currently have one or more high-interest debts—such as credit cards, store cards, or something else—you may be able to lower your monthly payments by consolidating your debt with a personal loan. This will allow you to make predictable monthly payments on one loan with a much lower interest rate.
How to Prepare for a Loan Application
There are several things you can do before you apply for a loan to ensure a smooth process. The few minutes it takes you to do these things can potentially save time so you can get the money you need as soon as possible.
Check Your Credit Score
In addition to your DTI ratio, your credit score is another important factor that lenders look at when considering you for a loan. You can obtain free copies of your credit reports each year from the three credit bureaus (Equifax, TransUnion, Experian).
Be sure to review these reports to make sure the information they contain is correct. If you spot an error, you can dispute it with the reporting bureau and possibly have it removed.
Gather Your Documents and Information
If you haven’t gathered all of the necessary documents when applying for a loan, it could cause delays. Although different lenders may request different documents, the following are typical:
- Tax returns
- Bank statements
- Proof of income
- Employment history
- Personal Identification
Make Sure Your Application Is Filled Out Correctly
Before you submit your loan application, be sure to review it to make sure that it is filled out correctly. An error could result in a delay or rejection.
Now Is a Great Time to Borrow
Now that you know more about DTI ratio, it’s time to consider if there are steps you can take to improve your percentage. A personal loan with TEG Federal Credit Union may be the perfect answer!
If you are thinking about applying for a personal loan, now is a great time to do it. The Federal Reserve is getting ready to raise interest rates, which means the cost of borrowing will soon go up. By applying for a personal loan today, you can lock in the current rate to protect you from future increases.
Check out the following to learn more about the benefits of personal loans and how borrowers will be affected by rate hikes.