Know Your Debt-to-Income Ratio and How to Optimize It

If you ever get to the point when you feel as though all of your money seems to go toward paying off debt, you are probably living on the edge of a high debt-to-income ratio (DTI). Your debt-to-income ratio is a measure of how much you are paying in debt each month versus how much income you receive. Suffice to say, the higher your DTI, the greater the strain on your financial situation. If your DTI is more than 40 percent, you are under financial stress and you should be doing everything you can to reduce your debt payments or make more money.

Calculating Your Debt-to-Income Ratio

If you want to know your DTI, it's easy to calculate. Simply add up all of your debt payments, including your mortgage or rent, car payment, credit card payments, student loan payment and any other debt payment. Then, add your sources of monthly income. You divide your total debt payment by your total income and the result is your DTI ratio.

Why Your Debt-to-Income Ratio is so Important

From your personal perspective, the DTI ratio is an important number to watch. The more it creeps up past 40 percent, the less wiggle room you have should your income suddenly drop or you have an unexpected expense. From the perspective of lenders and creditors, your DTI is an indication of how much risk you present. Looking to buy a home? Applicants with a lower DTI ratio will be able to qualify for a higher value mortgage, vs. those with high DTI ratios. Lenders view borrowers with higher DTI ratios as more likely to default. Though your DIT does not affect your credit score, it is sometimes more heavily weighted than your credit score. Don't confuse your DTI ratio with your credit utilization ratio, which is a big part of your credit score. Your credit utilization ratio is a measure of how much credit you're using compared to your credit limit.

Each mortgage lenders has their own DTI requirement; however, as a general rule, a DTI of 43 percent is thought to be the highest you can have and still qualify for a mortgage. Some lenders require a lower DTI ratio. If you have less than great credit, lenders may want to see a lower DTI ratio. Generally, for the best financial health and to expand your opportunities for getting a mortgage, it is recommended that you keep your DTI ratio to less than 36 percent with no more than 28 percent going towards mortgage expenses. Again, if you have less than great credit, you may want to reduce your ratio even further to less than 25 percent.

How to Lower Your DTI Ratio

There are two obvious ways to lower your DTI. You can make more money and/or you can reduce your monthly debt payments. As far as making more money, you know your capabilities or limitations better than anyone. If you can handle a side job or a small business on the side, you can increase your income. Any raise you have coming will reduce your DTI ratio as long as you don't increase your debts.

Pay Down Consumer Debt

Regardless of your ability to make more money, you should target debt reduction as your number one strategy. Your first target should be your credit card debt. The most effective way to slash your credit card debt is to stop paying for things on credit and then start living below your means. Then, budget for a big enough credit card payment to reduce your credit card debt by a meaningful percentage each month.

If you have a high interest credit card account, be on the lookout for a zero interest balance transfer offer. If you can transfer a balance and pay no interest for 12 to 18 months, you will be able to pay down your balance faster. Transferring to a zero interest account will also lower your DTI ratio because your minimum payment will be lower. You could accomplish something similar with a personal loan. With a personal loan, you could lower your monthly interest costs, which allows you to pay the balance more quickly. A personal loan can be an effective way to consolidate multiple credit card accounts for a more manageable payment.

Slash Your Student Debt

Unfortunately for student loan borrowers, student debt is also counted towards the DTI ratio and, for many, it can be an obstacle to reducing it. As with any other type of debt, the best way to reduce the balance and lower your overall costs is to pay it down more quickly. Student loans do not have prepayment penalties, so by making extra payments, you can reduce the balance and the interest costs. Making extra payments to your student loan won't reduce your interest rate or lower your required payments.

If your goal is to reduce your monthly payment, your best option is through refinancing. Private loans can be refinanced, and some lenders will also refinance federal loans into a new private loan. Although you could lower your interest costs, and therefore your monthly payment, the disadvantage is you will lose the protections you have under your federal loan. You would no longer be eligible for income-based repayment plans or loan forgiveness. However, with a lower interest rate, you should be able to make additional payments which can drastically reduce the term and cost of your loan.