This financial tool tells lenders all about your borrowing capacity.
Have you ever been rejected for a loan application?
After the initial sting of rejection faded, were you left wondering why?
If you have good credit and a decent income, it may be because your debt-to-income (DTI) ratio signalled to lenders that you weren’t a good loan candidate.
Your DTI is hugely important to the banks, credit unions and financial institutions you’d like to borrow money from.
If you want to avoid future rejections and access to the best interest rates out there, it’s time to get familiar with what makes for a good DTI.
What is a debt-to-income ratio?
A debt-to-income ratio is a tool lenders use to determine whether they believe you can manage additional debt.
A lower DTI ratio shows lenders you have sufficient income to balance your debt payments. Generally, with a lower percentage, you can expect to be approved faster and at better interest rates for any loans, lines of credit or credit card applications you make.
What lenders think when they look at a high DTI percentage is that it indicates you may have taken on too much debt for the amount of income you bring in. Most lenders would hesitate to lend you more money, making the assumption that you may not be able to actually consistently make an additional payment.
Is my DTI tied to my credit score?
No. Credit agencies don’t have access to any information about your income so they don’t have the figures to run the comparison.
Instead, your credit score is based on five factors, but primarily your payment history and your credit utilization.
But your DTI and credit score may still be linked in some ways. Let’s say you carry a lot of debt but have a long and consistent payment history. Payment history counts for about 35% of your credit score, so that looks positive for your score.
However, credit utilization makes up another third of your score.
Credit utilization is the measurement of how much of the credit you’ve used that is available to you. So if you have a credit card that has a limit of $10,000 and you currently have a balance of $7,500 on it, you’re utilizing 75% of your credit.
When you have a higher credit utilization, you’ll generally have a lower credit score. And carrying more debt on your credit card will also increase your DTI, regardless of your total income.
So while they’re not explicitly linked, both your credit score and DTI can be influenced by the same personal financial details.
What factors influence the average debt-to-income ratio?
Digging down further, there are two sets of ratios lenders consider when analyzing your DTI ratio. One looks at the front-end of your debt, while the other examines the back-end.
The front-end ratio is also sometimes known as the housing ratio. This shows what percentage of your monthly income goes towards your housing expenses, which includes your monthly mortgage payment as well as any property taxes, homeowners association fees and homeowners insurance.
Conversely, the back-end ratio deals with all your other monthly debts. Think your student loans, auto loan, credit card bills, child support or alimony and any other revolving type of debt you pay on a regular basis..