When applying for any new line of credit, especially a major one like a mortgage or auto loan, the lender needs some reassurance that you’ll be able to make your payments. In addition to checking your credit score, another metric that they’ll be interested in is something called your debt-to-income ratio. This figure is simply a ratio of your monthly recurring debts against your gross income.
Whereas your credit score lets a lender know how creditworthy you are, it doesn’t quantify the amount of free cash flow you have available. Therefore, they’ll want to know how much money you make and how many other debts you’re already obligated to pay.
As you might guess, the more debt you have, the less likely that you’ll be approved for the loan. But how much is too much? Here’s what you need to know about the debt-to-income ratio and how to make yours as low as possible.
How to Calculate Your Debt-to-Income Ratio
Calculating your debt-to-income ratio is fairly straightforward. Start by noting your gross monthly income – the earnings you’ve made before taxes and any deductions (such as retirement contributions or union dues) have been taken out. If you have a side hustle or any other notable income, include those amounts too.
Next, add up your monthly recurring debt payments. For most fixed-debt payments (such as an existing auto loan), this will be the full amount. However, for debt where the payment amount may vary (such as credit cards or student loan payments), you only need to include the minimum payment amount. This is because, from the lender’s perspective, you have the option to pay the smallest required amount if you ever needed to free up more cash flow.
Finally, divide your debt by your income.
Debt-to-Income Ratio = Monthly Debt / Gross Income
By multiplying the value by 100, you can convert the figure from a decimal to a percentage.
Debt-to-Income Ratio Example
Suppose you’d like to apply for a mortgage that will cost $1,000 per month. Currently, you’re already making the following monthly payments:
- Rent: $800
- Auto loan: $500
- Credit Card: $5,000 balance, $150 minimum payment
- Other debts: $350
Additionally, you also earn $72,000 per year before taxes.
In this case, you’d use the $1,000 mortgage (instead of the $800 rent) and the minimum $150 credit card payment. Therefore, your debt-to-income ratio would be:
($1,000 + $500 + $150 + $350) / $6,000 = 0.33 = 33%
What Is a Good Debt-to-Income Ratio?
Every lender has a different debt-to-income figure that they’re willing to accept. Generally speaking, most prefer the borrower’s value to be no more than 36 percent. Of that amount, no more than 28 percent of that debt should be going towards housing (either the mortgage or a rent payment).
Depending on the circumstance, some lenders (such as those for FHA loans) will accept a debt-to-income ratio as high as 43 percent. However, most will not exceed this figure because it’s considered to be too risky.
How to Improve Your Debt-to-Income Ratio
To put the best foot forward for any new loan or credit offer, the ideal condition is to have the lowest debt-to-income ratio possible. Here are a few ways to do this.
1) Pay Off Your Debts
Start by tackling the debt side of the equation. The fewer debt payments you have, the better your debt-to-income ratio will appear.
This can be done by targeting the debts with the smallest balances using the debt snowball method. The debt snowball is a strategy where you concentrate any discretionary income you can spare to accelerate payments toward the debts with the smallest balance. These are considered to be the lowest-hanging fruit because you’ll be able to knock them out quickly and remove their value from consideration when calculating your debt-to-income ratio.
2) Earn More Money
On the other side of the question is your income. The larger you can make this number, the smaller your debt-to-income ratio will be.
I know that earning more income is easier said than done. Depending on the job you have, it can be a lot of effort and time trying to get a raise or qualify for a new promotion.
For this reason, I’d encourage you to consider picking up a side hustle. There are many good ways to make money in addition to your current job by doing everything from simple data entry to being a virtual assistant. To browse different ideas, visit an online marketplace like Upwork or Fiverr and check out the types of jobs they have posted. If any of them seem like a fit for you, sign up as a freelancer and start applying for those gigs.
3) Reduce Your Interest Rate
Another creative way to reduce the amount of debt you have is to lower your interest rate. If you’ve got a revolving credit balance, then your minimum monthly payment will be impacted by the APR (annual percentage rate) that the credit card or loan provider is charging you daily. Hence, a lower rate can help you to lower the payment amount.
You may think it is impossible to persuade a lender to reduce your interest rate. However, if you’ve regularly made payments, you may have a good shot. Try contacting a customer support representative and explaining the situation. Even if they reduce your rate by a few percentage points or give you a temporary rate, that can make a difference.
4) Avoid Taking on New Debts
A little bit of planning can go a long way. In the months leading up to whenever you’d like to take out your loan, it would be a really good idea not to take on any new debts. This means no new credit cards or loans.
Instead, you’ll really need to watch your budget and make sure that you’re only spending as much as you can afford. A good way to do this is to use a budgeting app like Buxfer where all of your transactions will be automatically collected and condensed into a single dashboard. This allows you to know at all times where you stand and if any changes are needed.
Though it will take discipline, you’ll be in a much better position if you maintain a budget. This will not only help improve your debt-to-income ratio but also your overall financial foundation.
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