4 reasons your debt-to-income ratio is so important

min read

Authors: Motley Fool Staff

Source: The Motley Fool

Sometimes, less is more. The same is true of debt. The lower your debt-to-income ratio, the healthier your financial picture, and the more money you may end up with in your bank account.

What is debt-to-income ratio?

Debt-to-income (DTI) ratio measures the amount of your monthly income that goes toward making debt payments. It expresses the amount you owe in relation to how much you earn ­­­as a percentage. Potential lenders use your DTI to determine whether to lend you money.

Let's say you earn $6,000 per month and your monthly payments (including mortgage, car payment, and credit cards) come to $2,500. To find your DTI, you would divide $2,500 by $6,000: $2,500 ÷ $6,000 = 0.416, or just shy of 42%.

If you're applying for a mortgage or personal loan, your DTI is one of the factors a lender will consider. Different lenders have different criteria, but generally, a DTI of 36% or less makes it clear that you can manage your monthly payments. A DTI of 42% is just high enough to make lenders wonder if you're in too deep.

The maximum DTI a conventional mortgage lender will accept is 43% but many will look for a lower figure. Even if a lender will accept a higher DTI, it is important to consider whether you can afford additional payments, particularly if anything goes wrong.

Four benefits of keeping your DTI low

A low DTI may not be something you brag about at the bus stop, but it can make your life easier. If you carry less debt, you save money on interest payments. This gives you more money to save, invest in your future, and live the kind of life you want to live. Here are a few advantages to a low DTI:

1. Helps you qualify for loans

Let's say your oven bakes its last cherry pie. A repairman takes the stove apart, stands, places his hat over his heart, and bows his head in respect. The oven is officially dead. Your DTI is an important factor when you apply for a personal loan to finance a new oven. Your low DTI impresses potential lenders and you are offered a low interest rate and excellent terms on your loan.

A low DTI will also help you qualify for the best rates if you apply for a home loan. Mortgage rates are at historic lows, so whether you want to buy a home or refinance your existing loan, the lower your DTI the better.

2. Allows you to take advantage of financing deals

Imagine your current auto loan is at 6%, but your credit union offers a 2.75% interest rate to anyone who wants to refinance. You jump on the deal, knowing your DTI will impress the lender.

Having a low DTI and a high credit score could help you qualify for the best financing rates on the market.

3. Indirectly impacts your credit score

Credit reporting companies do not look at your DTI as they don't record your income. As such, your DTI does not directly impact your credit score. However, if you carry rotating debt -- such as credit cards -- it will affect your credit utilization ratio. This is the second most important factor in calculating your score and it's calculated by dividing the balance you carry by your total credit limits. Generally, it's best to keep your credit utilization below 30%.

Caring about your DTI has a secondary effect: It leads you to carefully monitor how much credit you carry. And the lower your credit card and other rotating debt, the healthier your credit score is likely to be.

4. Gives you peace of mind

There is power in a good night's sleep. DTI may not be as effective as melatonin, but the knowledge you're not carrying a lot of debt and have access to credit can help you rest your mind at night.

How to reduce your DTI

If your DTI is too high for comfort, these suggestions can help bring it down:

  • Pay down debt: Create a budget and a debt repayment plan. That way, you can slowly but surely rid yourself of unnecessary debt.
  • Earn more money: We all want to earn more money, but if you want to reduce your DTI, increasing your income is a sure-fire way to do it. Try enrolling in a program that adds to your skillset and makes you more employable. Consider a side hustle that raises your income and allows you to chip away at debt. Or you could even ask your employer what it would take to earn a promotion, and then take steps to make it happen.
  • Say no to new debt: It doesn't matter if all your friends buy new homes or cars, or go on fabulous vacations. Say no to anything you'd need to finance until your DTI is at a healthy level. Even then, think carefully before you dive into more debt.
  • Encourage yourself: Check your DTI regularly. Watching it come down may be all the encouragement you need to stick with it until lenders swoon at your ability to handle your finances.

Like a big toe, DTI may not seem like the most important thing in the world. But, also like a big toe, a low DTI offers balance and stability, two things worth working toward.

This article was written by Motley Fool Staff from The Motley Fool and was legally licensed through the Industry Dive publisher network. Please direct all licensing questions to legal@industrydive.com.