Your debt-to-income (DTI) ratio is one factor that lenders use to evaluate your application for credit and how likely you are to repay a loan. It represents the percentage of your income that you spend each month to service your debt obligations.
Underwriting lenders use this ratio to gauge your ability to pay back a loan. Your credit history, savings, and income will also be taken into account, but the debt-to-income ratio is often a major deciding factor.
Calculating Your DTI Ratio
Creditors will typically use a ratio based on your gross income, meaning the money you earn before taxes. The following equation represents your gross income:
Gross Monthly Income = your monthly income before taxes are deducted, plus any recurring and non-recurring income.
Your Outstanding Debts = your housing and auto loans and any other debts that you have to repay, including credit cards.The ratio is calculated by dividing your outstanding debts by your gross income, as shown in the following equation:
Debt-To-Income Ratio = outstanding debt/gross income
For example, you earn a gross monthly income of $4000 and have outstanding debts of $4600. Your debt-to-income ratio is calculated as follows:
Debt-To-Income Ratio = $4,600/ $4,000 = 1.1
This gives you a debt-to-income ratio of 1.1, meaning that you owe around 91 percent of your gross income to service your debts.
What Is Considered a Good Debt-To-Income Ratio?
Financial lenders look for a debt-to-income ratio of around 36 percent, although this number can vary based on the lender and the loan. Short-term or small to medium-sized loans such as personal loans or credit card loans would have a lower threshold for debt-to-income ratios, which are typically among the following ranges:
A good example is what is considered prime credit at a bank or credit union. Prime credit can be used to describe individuals with good credit scores, typically above 660 for FICO scores and above 650 for VantageScores.
On the other hand, non-prime is considered a lending category used by issuers to describe individuals with below-average credit scores. Typically, these individuals fall between 501 and 600 on FICO scores or below 600 on VantageScores.
In addition, mortgage lenders are usually more stringent with their DTI ratio requirements. For mortgage loans, a debt-to-income ratio of around 36 percent is considered a good indicator of your ability to repay your loan. If you have an excellent credit history and scores, you may be able to get a mortgage loan with a debt-to-income ratio below 36 percent.
How Your Debt-To-Income Ratio Affects Your Credit
Keep in mind that the lower your debt-to-income ratio is, the less risk you present to lenders. This translates into higher credit scores, which gives you access to better rates and terms from financial institutions, including lower interest rates and higher credit limits.
Financial institutions might be less likely to approve your loan application if you have a high debt-to-income ratio. This could mean that you have to have a co-signer or find a loan product with a higher interest rate.
Your Mortgage Experts at Desert Springs Mortgage
Your debt-to-income ratio is one factor considered by lenders when evaluating your loan application. A low debt-to-income ratio means that you have fewer outstanding debts, which presents less risk to lenders. This could translate into lower interest rates and better terms, including higher credit limits. Understanding how your debt-to-income ratio affects your finances is important when applying for a loan.
Are you looking for a mortgage lender in Phoenix? Turn to Desert Springs Mortgage, a full-service mortgage brokerage focused on the purchase market via realtor partnerships and more. We are licensed in Arizona, California, Colorado, Oregon, and Washington. Call us today at (623) 432-1309.