Understanding the Ideal Debt-to-Income Ratio
If you're considering applying for a loan, you may be wondering what constitutes a good debt-to-income ratio—and just as importantly, what the ideal debt-to-income ratio is for you.
This ratio calculates your monthly debt obligations relative to your gross monthly income—how much you earn before taxes and other deductions come out of your paycheck. Once calculated, debt-to-income ratio is expressed as a percentage. While it's a relatively simple number and concept, it can have a big impact on your financial life.
Why it matters
In its simplest form, debt-to-income ratio is a measurement that tells a mortgage company, credit card issuer, bank or private lender—anyone you hope to borrow money from—how much expendable monthly income you have relative to your existing monthly debt payments.
If your debt-to-income ratio is high based on the lender's criteria, it could indicate you'll have trouble making payments as agreed. Because a higher debt-to-income ratio is thought to mean you're a riskier borrower, some lenders may not approve you for a loan. If they do, they may require you pay higher interest rates to make up for the perceived risk.
Your debt-to-income ratio isn't part of your credit score calculation, and it's not shown on your credit report.
How it's calculated
Calculating your debt-to-income ratio requires only basic math. Start by making a list of all the monthly payments you make for debts like your mortgage, rent payments, home loans, car payment, credit cards, student loans, personal loans, and alimony or child support. Add them all up. Then, divide that number by your monthly income before taxes. The resulting number will be a decimal, but you can convert it into a percentage.
Here's an example. Suppose you pay $300 to your credit card each month, $400 for student loans, and $1,500 for your mortgage. Your total monthly debts are $2,200. Your annual salary is $95,000, so your monthly gross income is $7,916. Divide $2,200 by $7,916 for a resulting number of .28. Your debt to income ratio is 28%.
What's an ideal debt-to-income ratio?
Every lender has unique criteria they're looking for when making lending decisions. However, studies on housing affordability have shown that mortgage loan borrowers with a debt-to-income ratio higher than 43% may become unable to pay their monthly mortgage as agreed.
For that reason, lenders typically prefer a debt-to-income ratio of 43% or lower. However, some lenders may still approve borrowers with a debt to income ratio up to 50%, and so might private lenders for financial products like student loans.
How to improve
Paying down monthly debts—and eventually paying them off—is the most efficient way to improve your debt-to-income ratio. To decide which debts to pay off first, make a list of the monthly debts you carry, ordered from the highest interest rate to the lowest interest rate. Commit to paying more each month on your debt with the highest interest rate, as higher rates make loans more expensive long-term. Pay your other debts as agreed, and avoid taking on more debt in the process.
Monitor your progress every few months to stay motivated, and know where you stand. If you can't afford to pay more towards your monthly debts, consider reducing a few of your other non-essential expenses or taking on a temporary side gig to generate some extra cash.
If you're denied for a loan or offered unfavorable loan terms because you don't have what the lender considers an ideal debt-to-income ratio, don't get discouraged. With discipline and financial commitment, getting to an ideal debt-to-income ratio is completely within your control.
Stumped by the question: what is a good debt-to-income ratio? Find out your ideal debt-to-income ratio and how to make yourself a desirable borrower.
