HomeBAD CREDITWhy Debt To Income Ratio Is Important

Why Debt To Income Ratio Is Important

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debt vs income ratio

Ever applied for a loan, whether personal or mortgage, or for a credit card and been denied due to having a high Debt-To-Income ratio (DTI)?  Or maybe you were offered an interest high interest rate for the application for credit due to a high DTI?  If you are someone with a stable income with a long time at your job and who is still paying debts on time, you may have thought it silly to not be given credit or credit with cheaper terms for that reason alone.  However, there is a reason that lenders use that Debt-To-Income measure in conjunction with your credit history and stability to make a determination on credit.  Simply, individuals with DTI considered too high have less disposable income and are a higher risk of default.  So, how can you avoid having your plans put on hold due to a DTI that is too high?

What is a good Debt-To-Income ratio?

Typically, a ratio below 36% is ideal.  Depending on other factors like credit score and job stability some lenders may allow that number to be high and still provide you with credit.  But, remember, the higher the DTI the less favorable the terms will be, meaning higher interest rates and shorter terms.  

How Is The Debt-To-Income ratio Calculated?

DTI is calculated by adding up the monthly minimum payment on debts, divide that number by the gross monthly income, and multiply by 100.  The gross income is the income before tax and other deductions are taken.  Your take home income is not the gross income as it is the left over after taxes and deductions.  Regular monthly payments that are not debt, such are rent, electric, gas, phone, and food, are not considered for DTI.  The minimum payments on debts considered under this calculation would include even the minimum payment on debts that do not show on the credit report.  For instance a lender not on the credit report but that shows on the bank statement, taking regular monthly installments from the bank account, could be counted in the calculation for DTI.

Still Don’t Get It?  Here’s Some Examples

Example 1:  For this example, lets assume that the credit report shows that the minimum payment on credit card 1 is $25.00, the minimum payment on credit card 2 is $30.00, the minimum payment on a Personal Loan is $75.00, and that the minimum payment on a mortgage is $1000.00.  The total of minimum payment on these debts is $1130.00.  Assume no other debts show on the bank statement that are not already on the credit report.  If the gross monthly income totals $4520.00.  The divide the total of the minimum payments, $1130.00, by the gross income, $4520.  Multiply that figure by 100 to get at DTI of 25%. ( ($1130 / $4520) x 100 )

Example 2:  Assume you have the same minimum payments on the credit report as on Example 1.  But now the holidays came and you added extra credit cards and loans with minimum payments totaling $550.00.  So now we have added $550.00 to the minimum monthly payments of debts of $1130.00 from example 1.  The minimum monthly payments on the credit report then equal $1680.00 ($1130.00 + $550.00).  If we have the same gross monthly income as the previous example, $4520.00, then the DTI is 37% ( ($1680 / $4520) x 100 ).

Example 3:  Going back to Example 1, lest say that instead of getting debts during the holidays from companies that report to credit bureaus, you decided to get loans from creditors that don’t report to TransUnion, Equifax, or Experian.  However, the minimum payments for these non-reporting companies do show as deductions on your bank statements and these minimum payments total $600.00.  Even though these debts are not reported to a credit bureau, they can be counted towards the DTI as debt.  So these minimum payments would be added to the total of minimum of payments in the credit report, $1130.00, for a total of $1730.00.  The DTI, still assuming a gross income of $4520.00, would then be 38% ( ($1730 /$4520) x 100 ).

How To Lower The DTI?   

If your DTI is too high and is having and adverse effect on your financial planning, to lower the Debt-To-Income ratio, you could find a job with a higher salary or ask for a raise.  A raise on the gross income would lower the DTI, if more debt is not added.  But, that is may not be practical.  Also, it does not address the root problem which is you have too much debt.  To lower the DTI avoid taking on new debt.  Also, work on lowering the principal balances on the current credit cards and loans to as to pay them off sooner than later.  This may take more discipline.  But, in the end it may provide you with the financial standing to get better terms on future debts.

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