Each month, you have income and expenses. You likely also have debt, such as credit card balances or student loans. If you owe too much, a sudden drop in your income can cause big problems, which is where your debt-to-income (DTI) ratio comes in. Your DTI can offer some valuable insight into how much money is coming in versus going out.
Here’s what to know about your DTI, how it’s calculated, and why it’s important.
What Is a Debt-to-Income Ratio?
Your DTI provides some insight into your debt relative to your gross monthly income. Your gross monthly income is your total income from all sources before taxes and other deductions are taken out. Here’s how to calculate your DTI:
DTI = (Total of your monthly debt payments/your gross monthly income) x 100
Example: Let’s suppose your gross monthly income is $5,000, and you pay $1,500 a month to cover your mortgage, plus $350 a month for your student loans. You have no other debt. Your total monthly debt payments amount to $1,850.
Your DTI is (1,850/5,000) x 100 = 37%
Here’s a handy calculator to estimate your DTI.
Why Is Your DTI Important?
Your DTI is important to keep an eye on because it tells you whether your financial situation is good or precarious. If your DTI is high, 60% for example, any blow to your income could leave you struggling to pay down your debt. If you are hit with some unexpected expenses (e.g., medical bills or your car needs expensive repairs), it will be harder for you to keep on top of your debt payments than if your DTI were only 25%.
Apart from being an important metric to track on your own, lenders will also likely look at your DTI if you apply for financing. This ratio serves as an important measure of risk. If you have a high DTI, you’ll be regarded as more likely to default on a loan.
What Is Considered a Good DTI?
If you apply for a mortgage, your DTI will be calculated as part of the underwriting process. Usually, 43% is the highest DTI you can have and likely receive a qualified mortgage. (A qualified mortgage is a preferred type of mortgage because it comes with more protections for the borrower, e.g., limits on fees.)
If 43% is the top level DTI you can have for a qualified mortgage, what is a “good” DTI? According to NerdWallet, a DTI of 20% or below is low. A DTI of 40% or more is an indication of financial stress. So, a good DTI may fall between these two figures, and in general, the lower, the better.
How to Lower Your DTI
If your DTI is currently high and you’d like to reduce it, whether to apply for financing or simply for a bit more financial wiggle room, here are a few potential steps to take:
Track your budget: Budgeting and reducing non-essential spending may also help lower your DTI.
Pay down debts: Making a plan to pay down your debt is a good first step to a lower DTI.
Refinance when it makes sense: Strategic refinancing may also help. For example, you might refinance to a longer-term loan to help reduce your monthly payments. Just remember that you could end up paying more interest over the long term.
Considering Student Loan Refinancing to Lower Your DTI
Taking steps to lower your DTI can reduce stress and give you more control over your finances. Depending on your current student loan term and rate, refinancing student loans may reduce your monthly payment, which could help bring down your DTI. It can also free up extra cash for other goals.
Ready to learn more? ELFI can help you explore the benefits of refinancing your student loans on your financial goal timeline.
