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[Prefer to listen? You can find a podcast version of this article here: E231: What is a Good Debt to Income Ratio?]

The debt-to-income (DTI) ratio is a financial metric that compares an individual's monthly debt payments to their gross monthly income.

To understand your debt-to-income ratio (DTI), you need to know how it affects your financial health and loan eligibility. Lenders use your DTI to see if you can manage monthly debt payments compared to your income. This ratio helps them decide if lending to you is a safe bet.

Calculating your DTI is simple. Start by adding up all your monthly debt payments. This includes your mortgage or rent, car loans, student loans, credit card payments, and any other regular debts. Next, divide this total by your gross monthly income, which is your income before taxes and deductions. The result is your DTI percentage.

For example, if you pay $2,000 each month towards debts and your gross monthly income is $6,000, your DTI is 33%. ($2,000 ÷ $6,000 = 0.33, or 33%). This means 33% of your income goes to debt payments.

Keeping a low DTI is important. It shows lenders you can handle your debt and makes you a more attractive borrower. A lower DTI can help you get better loan terms, like lower interest rates and higher borrowing limits.

A healthy DTI also benefits your overall finances. It ensures you have enough money for living expenses, savings, and investments. A high DTI, on the other hand, can strain your finances and hinder your financial goals.

What Constitutes a Good Debt-to-Income Ratio?

To determine what constitutes a good debt-to-income ratio, lenders have set benchmarks to assess a borrower's financial health. Generally, a debt-to-income ratio of 36% or lower is ideal. This means that your debt is manageable compared to your income. For example, if your monthly debt payments are $1,800 and your gross monthly income is $5,000, your DTI would be 36%. ($1,800 is 36% of $5,000.)

Of course, when it comes to debt, lower is always better. A DTI of 0% is ideal, but if that's not practical, aim for a DTI that is as low as possible.

When applying for a mortgage, most lenders prefer a DTI of no more than 43%. This higher threshold accounts for the significant financial commitment of a mortgage. For instance, if your monthly debts, including a new mortgage, total $2,150 and your gross monthly income is $5,000, your DTI would be 43%. ($2,150 is 43% of $5,000.) Some lenders might require a lower DTI if you have a lower credit score or limited savings.

For other loans, like personal or car loans, lenders might accept a higher DTI, sometimes up to 50%. However, a higher DTI can lead to less favorable loan terms, such as higher interest rates or shorter repayment periods. For example, if your monthly debts are $2,500 and your gross monthly income is $5,000, your DTI would be 50%. ($2,500 is 50% of $5,000.)

However, remember that what a lender will accept is not the same as a "healthy" DTI. Most financial advisors will generally agree that a "28/36" debt-to-income ratio is ideal. In other words, try to spend no more than 28% of your monthly income on housing expenses and no more than an additional eight percent on debt, so that total debt service does not exceed 36% of your monthly income.

Maintaining a low DTI can help you secure better loan terms. Lenders see a low DTI as a sign of financial stability, which can result in lower interest rates and longer repayment terms. Conversely, a high DTI can make it harder to get loans or lead to less favorable terms. For example, if your DTI is 25%, you might get a lower interest rate than if your DTI is 45%.

A good DTI also contributes to overall financial well-being. By keeping your debt levels manageable, you can ensure you have enough funds for living expenses, savings, and investments. This financial stability can help you achieve long-term goals, like saving for retirement or buying a home. On the other hand, a high DTI can cause financial stress and limit your ability to reach these goals.

Strategies for Improving and Maintaining Your Ratio

Improving and maintaining a good debt-to-income (DTI) ratio is important for financial stability and getting better loan terms. Start by focusing on paying down your existing debt. Use extra funds to pay off credit card balances, student loans, or car loans. This will lower your monthly debt payments and reduce your DTI. You can try the debt snowball or debt avalanche method. The debt snowball method targets the smallest debts first, while the debt avalanche method focuses on the highest interest rates. As you pay off each debt, use the money saved to pay off the next one, creating a snowball effect.

Another way to improve your DTI is to increase your income. You can do this by asking for a raise, taking on extra hours at work, or finding a higher-paying job. You might also consider starting a side hustle or freelancing to supplement your income. By earning more while keeping your debt the same, you can lower your DTI and show lenders that you can handle your debt well.

Avoid common mistakes when working on your DTI. Don't take on new debt while paying off existing obligations. Opening new credit card accounts or taking out more loans will only increase your monthly debt payments and your DTI. Also, make sure to create and stick to a budget. Track your income and expenses to find areas where you can save money and use those savings to pay off debt or build up savings.

Maintaining a good DTI over time requires discipline and smart financial habits. Once you achieve a favorable DTI, live within your means, avoid unnecessary debt, and regularly check your credit report for accuracy. Set financial goals and create a plan to achieve them. Building an emergency fund can also help you handle unexpected expenses without relying on credit cards or loans, which can negatively impact your DTI.

By following these strategies and staying committed, you can improve and maintain a good DTI. This will enhance your financial well-being, increase your chances of getting better loan terms, and give you more financial flexibility to pursue your long-term goals. Achieving and maintaining a healthy DTI is an ongoing process that requires consistent effort, but the rewards are worth it.

Conclusion and Key Takeaways

Understanding and maintaining a good debt-to-income (DTI) ratio is essential for achieving financial stability and securing favorable loan terms.

To improve your DTI, focus on strategies like paying down existing debt, increasing your income, and avoiding new debt.

Regularly monitor your DTI, set financial goals, and create a plan to achieve them. Building an emergency fund and living within your means can prevent you from relying on credit.

Achieving and maintaining a good DTI is an ongoing process that requires commitment. By understanding the importance of DTI and taking steps to improve it, you can secure favorable loan terms and achieve your long-term financial goals.

Debt-to-income is a key financial metric. It reflects your financial health and helps you build a stable and prosperous future.