Defining the Debt-to-Income (DTI) Ratio
The debt-to-income ratio is an equation that will include the fixed monthly obligation that you have, which is further on divided by your gross income (the one before taxes are applied). The result is a percentage that lenders use in order to determine your ability to make monthly payments.
This equation will include a variety of payments. You will have your minimum monthly credit card debt, your rent/mortgage, your student loans – even child support if that is the case. Every fixed payment needs to be added to the calculation.
Overall, the equation for your debt-to-income ratio should look something like this:
DTI = Total Monthly Debt Payments / Gross Monthly Income
This equation might seem rather confusing to some people. While it might look like it includes all of your recurring payments, it is not always the case. Expenses such as your monthly utility bills, insurance, or variable expenses are not included.
For this reason, the DTI is not always completely understood by those who have nothing to do with the lending industry. Some fixed expenses are calculated, but others are taken out.
This is why it can usually be quite difficult to know exactly what your debt-to-income ratio is before you apply for a loan. Most of the time, the lender will be the one to calculate it.
How Your Credit Is Affected
Generally, around 30% (or under 40%) of your FICO score is determined by your DTI. Since it is a decisive aspect of most lending decisions, you might understand why it is quite influential.
Ideally, you might want to keep your debt-to-income ratio at a low level (lower than 40%. Not only will a higher ratio cause the lenders to eye you suspiciously, but it might also send you into financial stress.
The higher your DTI ratio, the more your finances will become slightly uncomfortable for you. Indeed, you may be able to make minimum payments on each debt – but as time goes by, it will become quite difficult to handle. The higher your DTI goes, the worse your credit will become.
For this reason, you might ensure that you have your DTI checked at least every few months. This way, you will make sure that you will not be entering a cycle of debt that will bring down your finances.