Calculating Debt to Income Ratio:
Why It Matters & How To Find It
You already know that your credit score matters.
And I guess I always knew it too, but the importance of maintaining good credit really hit home for Matt and I was when we bought our first house.
We were 21, expecting our first child, and I was only 4 months out of college. We weren’t initially planning to buy a house, but making an 1.5 hour drive each way to work every day, being pregnant, and renting were not a good combination for us, so we decided to look at fixer-uppers.
Eventually we settled on a $40,000 HUD home, put in a bid, and won!
But that was where to the good news ended.
We had planned to buy the house with both of our names on the loan, but when it came time to hand over our documents to underwriting, we discovered a giant problem: Matt’s credit.
Before you think the credit problem was his fault, let’s get something out of the way: it wasn’t.
See, his parents had added him to their credit card account when he was only 6 months old. Then for 18 years, they had faithfully paid off their balances every single month, effectively building his credit into a perfect score.
That 18 years of perfect credit history was what made up most of his credit score. (Mine was good, but I only had 4 years of credit history)
As it turns out, just as we were getting set to buy the house, his parents credit card numbers were stolen, so they had to get new card numbers – and there was a 30-day period where Matt effectively had NO CREDIT.
In 30 days it was resolved, but in 30 days we would lose our winning bid on the house.
Tough situation, right?
We thought about looking for a different house, letting the one we bid on go, but then our mortgage office presented us with a different idea: to buy the house in my name only. Then, when the stolen credit card situation was figured out and we got Matt’s credit back, we could either refinance in both of our names, or just leave it as is.
And that’s where my Debt to Income Ratio came in – hard.
Buying a house on your own is not all that hard – provided your debt to income ratio is low enough.
But with only using my income to qualify for the mortgage – and ALL of our shared debt – essentially my debt to income ratio doubled.
In the end, it was ok: We bought the house, moved in, and lived happily ever after.
So why did I spend the time telling you this story?
Because Debt to Income Ratio matters. It matters if you have no debt, a little debt, lots of debt, if you’re planning on obtaining more debt, or if you just want to maintain or improve your credit score.
Here are many of the things that Debt-to-Income Ratio affects:
- Your credit score: Though it is not the largest factor, Debt-to-Income ratio is factored into your credit score. A Debt-to-Income ratio of 40% or larger will negatively affect your credit score.
- Your employment prospects: potential employers often run your credit, which is affected by Debt-to-income ratio, because it is an indication of how responsible your are with your finances.
- Loan qualifications: Lenders look at your Debt-to-Income Ratio using the method I will show you when offering you a loan for anything from a vacation to a home. If your Debt-to-Income ratio gets too high, they can refuse you the loan altogether.
- Interest rates: As your Debt-to-Income ratio creeps higher, you are considered a bigger risk to loan money to by banks, so your interest rate on loans will go up. Banks use your credit score and Debt-to-Income ratio to put you into a risk bracket – and you have to be in the best bracket to qualify for the best rates.
How To Calculate Your Debt-to-Income Ratio (DTI)
Your DTI calculates how much of your monthly income is going toward debt payments and other obligations.
These are the payments that should be factored into your DTI:
- Monthly Rent or Mortgage
- Monthly Credit Card Minimum Payments
- Monthly Auto Loans
- Monthly Student Loans
- Monthly Child Support
- Monthly Alimony Payments
- Monthly payments on any other loans: personal, recreation, etc.
Add up all of the above debt payments and obligations, then divide by your monthly pre-tax income (gross income).
Here is an example from our own finances:
Our monthly debts:
- Mortgage: $835
- Investment Property Mortgage: $747
- 0% Interest Credit Card: $150
- Student Loan: $135
Total Debts: $1,867
Our Monthly Gross Income: $9,450
Using the DTI formula: $1,867/$9,450 = 0.1975 x 100 = 19.75%
So, our DTI is 19.75%
Want to make it even easier? Use this DTI Calculator.
How Does Debt-to-Income Ratio Affect My Credit Score?
Your DTI DOES affect your credit score, as I mentioned above, but it’s in a roundabout way.
Your credit score is determined by the following factors:
- Payment History – 35%
- Credit Utilization – 30%
- Length of History – 15%
- New Credit – 10%
- Types of Credit – 10%
The Credit Utilization portion of your credit score is determined by how much of your available credit (on credit cards) is being used by not paying off your balance in full ever single month. While this isn’t a true DTI – because it only takes credit card usage into account – it is a part of your DTI and affects your credit score in a big way. To avoid any negative impact to your credit score, keep your credit usage on individual cards and in total below 30%.
So, 30% of your credit score is determined by how much of your available credit on credit cards is being used.
Keep your balances – total and individually – below 30% for optimal credit score health.
What DTI is needed to qualify for a loan?
Banks and credit unions sets their own DTI’s to qualify for loans and iterest rates. However, you can expect to see about 36% for a conventional mortgage, and up to 45% for things like auto loans.
With DTI, it’s best to aim low to ensure you not only qualify for the loans you want, this ensures that you’re getting the best interest rates, and that you’re being smart with your money and budget.
How To Fix Your Debt-to-Income Ratio
If you just did your DTI calculation and found that yours is higher than it should be, it is time to make changes and fix it. Lower is better when it comes to credit card utilization and Debt-to-Income ratios, so here are some ways to get that number lower:
- Stop Using Credit Cards: Just stop charging things on your cards. No need to cut them up, just “un-remember” them from your favorite online stores, and take them out of your wallet. You can either use cash from your bank account to pay for things, or your debit card (link.)
- Make a Budget: Make sure you have enough money for the necessities – paid either in cash or by debit card – by making a budget and sticking to it. Many people find the cash envelope system helpful – here is my family’s method for making a budget.
- Track Your Spending: My budgeting method makes this extremely easy, because it syncs your bank accounts with an app. You’ll be reminded of whether you’re within budget very easily! Or, if you prefer the pen & paper method, you can always tracking your spending that way.
- Pay off Your Debt – Start with your lowest debt balance, and put everything extra you have towards that balance each month. When you pay it off, move on to your next lowest debt, and continue until you’re debt free! This is called a debt snowball, and it is extremely effective!
- Earn More Money – Take on a side hustle, do some online work, start a blog and whatever else you can do to increase your income. Take everything extra you make and throw it at your debt to get the snowball rolling faster and faster, until you’re debt free!
Your goal should, of course, be to be eventually be debt free. But as you work towards our goal, keep a record of your Debt-to-Income ratio as it drops lower and lower for motivation. Getting your Debt-to-Income ratio under control is the key to good credit, good interest rates, and a responsible financial life.
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