- Debt-to-income ratios compare your monthly debt to your income.
- Lenders use debt-to-income ratios to determine your ability to balance your budget and pay back all of your loans.
- Forty-three percent is generally considered the highest debt-to-income ratio permissible to qualify for a mortgage.
Your debt-to-income ratio compares your monthly debt to your monthly income. It shows your ability to balance your budget and allows lenders to gauge whether they think you'll pay them back. If you borrow too much, you may hurt your chances at obtaining future loans and mortgages, and that first home you were hoping to buy might slip out of your reach.
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What is a debt-to-income ratio and why is it important?
"In the simplest terms, debt-to-income ratio basically means how much you owe versus how much you earn,” Mayer Dallal, managing director at mortgage lender MBANC, says. “If you have a lot more debt than you have income, it raises questions about your ability to pay back what you have borrowed, which is what lenders are analyzing when they are reviewing a loan application.
Much like your credit score, your debt-to-income ratio helps inform prospective lenders about your ability to repay loans. It does this by comparing your monthly debt—things like mortgage or rent payments, student loans, auto loans and minimum credit card payments—to your gross monthly income, or your salary before the government takes its share in taxes. Dividing your debt by your income gives you your debt-to-income ratio.
What is a good debt-to-income ratio?
While debt-to-income standards differ from lender to lender, the lower the number, the better you look.
Generally speaking, a debt-to-income ratio around 35% or lower is considered to be manageable and you shouldn’t have any issues accessing new lines of credit.
But the higher your debt-to-income ratio goes, the riskier you look as more of your income goes towards paying bills.
If you have a high debt to income ratio—often anything above around 40%—then a lender may think that your current income may not stretch far enough to cover a new line of credit. As a result, your loan request may be denied or you may only be offered a loan at a high interest rate.
"After credit scores, debt-to-income ratio is one of the biggest things we look at as a mortgage lender. So if you're applying for a loan, if you pay down your outstanding balances, it really beautifies you as a borrower,” Dallal says.
While all lenders look at debt-to-income ratios, it is particularly important when it comes to taking out a mortgage. Lenders typically look for a debt-to-income ratio of 36% or lower when considering mortgage applications, but some lenders will go up to 43% or higher in certain situations, according to The Consumer Financial Protection Bureau (CFPB). Large lenders have to make a reasonable, good-faith effort to determine if you have the ability to repay the loan, according to the CFPB.
Lenders will also look specifically at your mortgage debt-to-income ratio (your expected monthly mortgage payment divided by your monthly gross income) when considering your mortgage application. Ideally this should be 28% to 35%, according to the CFPB.
Calculating your debt-to-income ratio
There are plenty of debt-to-income ratio calculators available online (such as from Zillow) that make finding your debt-to-income ratio quick and easy, but let’s take a look at an example of debt-to-income and how to calculate it:
Larry works as a full-time software engineer in Cincinnati. He does well and makes about $102,000 a year. He has a nice two-story home, a Volkswagen Tiguan and student loans from his Iowa State University bachelor's degree. His costs are as follows: Larry pays $2,100 a month for his mortgage, $350 for the car loan and $200 in student loans. He also has a total of $100 in minimum credit card payments for a total monthly debt of $2,750. His gross monthly income is $8,500. Larry’s debt-to-income ratio is 2,750/8,500, or 32%.
That's a pretty good ratio and a lender is likely to provide him with a loan or mortgage.
Does my debt-to-income ratio affect my credit score?
Nope. Your debt to income ratio doesn't impact your credit scores. It’s just one more data point that lenders will use in evaluating your credit application.
How can I lower my debt-to-income ratio?
As noted above, the higher your debt-to-income ratio, the less likely a lender will want to provide you with a loan or mortgage. There are, however, ways to improve your debt-to-income ratio.
Order less take out, make more payments. If you increase the amount you pay toward your debt, you can lower the overall amount more quickly.
That big trip to Hawaii you've always dreamed of taking? Perhaps push it off a year to avoid taking on more debt. Also, leave the credit card at home (and turn off your mobile phone wallet) when out and about to discourage spending.
Build up your down payment for a big purchase. That means you'll need less credit, which can keep your debt-to-income ratio in check.
Keep a close eye on that debt-to-income ratio. Bank of America calls it a motivating factor to keep debt manageable.
Is debt ever a good idea?
At this point you may be thinking all debt is bad, but that’s not true. Good debt typically pays for something that has long-term value and helps you increase your wealth over time, like a house. Your mortgage may be your most significant monthly payment, but it’s also paying for what is likely your most valuable asset, and that value is (hopefully) going to increase over time.
Any investment that helps you generate income in the long-term can generally be considered good debt. Other examples include student and business loans.
So keep an eye on that debt-to-income ratio so you can make the best and savviest decisions for your family's financial health.