Lenders use a number of metrics to determine what kind of rates a borrower is eligible for. One of the most important is debt-to-income ratio (DTI), which refers to the discrepancy between how much debt a borrower is holding and their current level of income. So why is this metric so important, and what can you do to improve it? We’ve got the answers you need below.
Why Does Debt-to-Income Ratio Matter?
DTI is important because many lenders, especially mortgage companies, use it as a benchmark to decide how much of a loan you will qualify for. When you apply for a mortgage, the lender will calculate your current DTI and use it to determine what you can really afford to pay back. Most lenders allow a maximum DTI of 36%, but some lenders allow up to a 43% DTI. These percentages will also include your future mortgage payments. The lower your DTI is right now, the higher the mortgage payment you’ll qualify for. Lowering your DTI before you apply for a mortgage will increase your housing budget.
How to Reduce Your Debt to Income Ratio
If your DTI is too high to qualify for a loan, read below for some strategies to decrease the ratio:
Pay Off Smallest Individual Loans
The simplest way to reduce your DTI quickly is to pay off small individual loan balances. For example, you have an auto loan with a $300 monthly payment and a $2,000 balance. You also have student loans with a $350 monthly payment and a $20,000 balance. You earn $40,000 a year, so your current DTI is 19.5%. Instead of throwing extra money toward your student loans, add any extra money to your auto loan until you can pay it off. If you do that, your DTI will drop to 10.5%.
Reduce Credit Card Interest
If you have credit card debt, you likely have a high-interest rate. This can make paying down the balance difficult. If possible, try to transfer your credit card debt to a new card with a 0% APR balance transfer offer. Most balance transfer offers last between 12 and 20 months. You won’t be charged any interest during that time, and all your payments will go toward the principal. Reducing the credit card balance will also reduce your monthly payment and your DTI. If you don’t qualify for a 0% APR offer, call your credit card provider and ask them to lower the interest rate on your card. Remind them that you’ve been a loyal customer and that you’ve always paid on time. Try this strategy for all your credit cards to decrease your DTI.
Increase Your Income
Paying off debt is difficult, but increasing your income can make the process easier. It can also reduce your DTI. When you increase your income, your DTI will automatically decrease. And if you use the extra money to pay off your debt faster, that will also reduce your DTI. Start by asking for a raise at work. Prove your value to the company by creating a list of ways you’ve saved your employer money or increased the company’s revenue. If a raise isn’t possible or you’ve already received one recently, think about starting a side hustle. Side hustle income can count as part of your total income for DTI, but remember that filing taxes for your side hustle income is important. Plus, you can put the extra money toward your debts.
Take Fewer Deductions
If you’re self-employed, your DTI is based on your post-tax or net income, not your pre-tax or gross income. And because many self-employed individuals take a lot of business deductions to reduce their tax burden, they often wind up with a low taxable income. If you’re planning on buying a house soon, consider taking fewer deductions to increase your net income. This may result in a higher tax burden, but it can make qualifying for a mortgage easier.
Refinance Your Loans
Refinancing your loans to reduce your monthly payment can greatly impact your DTI. For example, you owe $30,000 in student loans with a 10% interest rate and a 10-year term. Your monthly payment is $396.45. Your annual income is $50,000, which means your current DTI is 9.5%. If you refinance to a 5% interest rate and a 10-year term, your new monthly payment will be $318.20. This means your new DTI will be 7.6%. If you want to reduce your DTI further, you can refinance to a longer repayment term. Longer repayment terms have lower monthly payments than shorter repayment terms, resulting in a lower DTI. For example, if you refinance to a 15-year term and a 5% interest rate, your new monthly payment will be $237.24. This would reduce your DTI to 5.7%. The only downside of refinancing to a longer-term is that you might end up paying more in total interest over the life of the loan than if you refinanced to a shorter term. However, you can always pay extra on your loan and avoid the extra interest while lowering your DTI.
Refinance Student Loans with ELFI
If your student loans impact your DTI, consider refinancing them to reduce the monthly payment. If you refinance with ELFI, you’ll receive access to a personal loan advisor who will guide you through the refinancing process.* Use ELFI’s student loan refinance calculator to see how much you could save.
