How to Lower Your Debt-to-Income Ratio

Share

Your debt-to-income (DTI) ratio is an important part of assessing your financial health and securing favorable loan terms. The DTI ratio measures how much of your monthly income goes toward paying off debts, giving lenders a clear picture of your financial capacity. If you’re looking to improve your financial situation, learning how to lower your debt-to-income ratio can help you get better loan options and financial stability.

What Is Debt-to-Income Ratio?

The debt-to-income (DTI) ratio is a metric used by lenders to assess a borrower’s ability to manage monthly payments and repay debts. It is calculated by dividing total monthly debt payments by gross monthly income and is expressed as a percentage.

A good DTI ratio is typically below 36%, with no more than 28% of that debt going towards servicing your mortgage. This is considered healthy and indicates you have a manageable level of debt compared to your income.

On the other hand, a DTI ratio above 43% is generally seen as poor. This suggests that a significant portion of your income is going towards debt payments, which can be a red flag for lenders and may indicate financial stress.

Front-End vs. Back-End DTI

There are two types of DTI ratios: front-end and back-end. The front-end DTI ratio, also known as the housing ratio, includes only housing-related expenses, such as mortgage payments, property taxes and insurance. The back-end DTI ratio includes all monthly debt obligations, such as housing expenses, car loans, student loans and credit card payments. Lenders typically look at both ratios when evaluating a borrower’s creditworthiness.

Calculating DTI

To calculate your DTI, add up all your monthly debt obligations, such as mortgage or rent, car loans, student loans and credit card payments. Then, divide this total by your gross monthly income (your income before taxes and other deductions). For example, if your monthly debt payments are \$2,000 and your gross monthly income is \$5,000, your DTI ratio is 40% (\$2,000 ÷ \$5,000 = 0.4 or 40%).

Consider a homeowner who has a monthly mortgage payment of \$1,200, a car loan payment of \$300 and a student loan payment of \$500, totaling \$2,000 in monthly debt payments. This person’s gross monthly income is \$6,000. Their front-end DTI ratio, which includes only their housing expenses, is 20% (\$1,200 ÷ \$6,000). Their back-end DTI ratio, which includes all their debt payments, is 33% (\$2,000 ÷ \$6,000).

Why Is Debt-to-Income Ratio Important?

Lenders use this ratio to gauge your ability to manage monthly payments and repay debts. A lower DTI ratio suggests that you are less risky, which can improve your chances of loan approval.

Your DTI ratio also influences the interest rates offered by lenders. Borrowers with lower DTI ratios are often perceived as more financially stable and are therefore likely to secure better interest rates. This can significantly reduce the overall cost of borrowing.

How to Lower Your Debt-to-Income Ratio

Lowering your debt-to-income ratio requires strategic actions like increasing your income, paying off small loans, refinancing, consolidating debt, avoiding new credit and possibly adding a co-signer. Each of these steps can help you achieve a healthier financial position and improve your prospects for securing loans and favorable interest rates.

One effective way to lower your DTI is to increase your income. Consider asking for a raise at your current job or taking on a second job or freelance work. Additional income boosts your earnings, thereby reducing the percentage of your income that goes toward debt repayment.

Pay Off Smallest Loans

Paying off your smallest loans can have a quick and positive impact on your DTI ratio. By eliminating smaller debts first, you reduce the number of monthly payments you need to make, which can significantly lower your overall debt burden. This approach, often referred to as the snowball method, can also provide a psychological boost as you see debts disappearing one by one.

Refinance Loans

Refinancing existing loans can lower your monthly payments, helping to reduce your DTI ratio. By securing a lower interest rate or extending the loan term, you can decrease the amount you have to pay each month.

Consolidate Debt

Debt consolidation involves combining multiple debts into a single loan, usually with a lower interest rate and a more manageable monthly payment. This can simplify your debt repayment process and potentially lower your monthly obligations. Consolidation loans are available through banks, credit unions and specialized financial institutions.

Avoid Using Credit

Limiting the use of credit cards and other forms of borrowing is essential when trying to lower your DTI ratio. Each new charge adds to your overall debt, increasing your monthly payment obligations. Focus on using cash or debit cards for purchases to avoid accumulating additional debt.

Adding a borrower or co-signer to your loan can improve your DTI ratio. This person’s income is combined with yours, which can lower your overall DTI ratio. However, be mindful that the co-signer will be equally responsible for the debt and any missed payments can affect their credit score. Additionally,  it will increase their DTI.

What’s the Max DTI for a Mortgage?

Different mortgage variations have different DTI thresholds and requirements. For example, a borrower may qualify for a conventional loan or Federal Housing Administration loans with a DTI as high as 57% (though the preferred DTI is 43%). However, the requirements for other government-backed loans can be significantly lower.

Understanding the following thresholds can help potential borrowers assess their financial health and explore options to lower their DTI ratio, improving their chances of loan approval and favorable terms.

• Conventional loans: Lenders usually prefer a DTI ratio of 36% or lower. However, some may allow up to 45% if the borrower has strong compensating factors such as a high credit score or substantial savings.
• FHA loans: The Federal Housing Administration (FHA) allows a higher DTI ratio. The front-end DTI (housing expenses) should be below 31% and the back-end DTI (total monthly debt) can go up to 43%. In some cases, borrowers with strong profiles may be approved with DTIs up to 57%.
• USDA loans: The U.S. Department of Agriculture (USDA) sets a maximum DTI ratio of 41% for automatic approval. This includes both housing costs and other debt payments, although higher ratios might be considered with compensating factors.
• VA loans: The Department of Veterans Affairs (VA) doesn’t set a strict maximum DTI ratio. However, a ratio of 41% or lower is generally preferred. Higher ratios may be acceptable if the borrower has residual income that meets VA guidelines.

Bottom Line

By managing and lowering your DTI, you can improve your financial health and stand a better chance of securing favorable loan terms. Through diligent planning, strategic debt management and consistent efforts to increase income, you can achieve a more balanced financial profile. This not only boosts your borrowing potential but can also pave the way for a more stable and prosperous financial future.