by Dana George | Updated Sept. 15, 2021 - First published on Oct. 24, 2020
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A low debt-to-income ratio can make your financial life easier.
Sometimes, less is more. For example, a low ratio of body fat, low ratio of cats to humans in a small apartment, and low ratio of students to teachers in a classroom tend to be healthier than high ratios.
The same is true of debt. The lower your debt-to-income ratio, the healthier your financial picture, and the more money you may end up with in your bank account.
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Debt-to-income (DTI) ratio measures the amount of your monthly income that goes toward making debt payments. It expresses the amount you owe in relation to how much you earn as a percentage. Potential lenders use your DTI to determine whether to lend you money.
Let's say you earn $6,000 per month and your monthly payments (including mortgage, car payment, and credit cards) come to $2,500. To find your DTI, you would divide $2,500 by $6,000: $2,500 ÷ $6,000 = 0.416, or just shy of 42%.
If you're applying for a mortgage or personal loan, your DTI is one of the factors a lender will consider. Different lenders have different criteria, but generally, a DTI of 36% or less makes it clear that you can manage your monthly payments. A DTI of 42% is just high enough to make lenders wonder if you're in too deep.
The maximum DTI a conventional mortgage lender will accept is 43% but many will look for a lower figure. Even if a lender will accept a higher DTI, it is important to consider whether you can afford additional payments, particularly if anything goes wrong.
A low DTI may not be something you brag about at the bus stop, but it can make your life easier. If you carry less debt, you save money on interest payments. This gives you more money to save, invest in your future, and live the kind of life you want to live. Here are a few advantages to a low DTI:
Let's say your oven bakes its last cherry pie. A repairman takes the stove apart, stands, places his hat over his heart, and bows his head in respect. The oven is officially dead. Your DTI is an important factor when you apply for a personal loan to finance a new oven. Your low DTI impresses potential lenders and you are offered a low interest rate and excellent terms on your loan.
A low DTI will also help you qualify for the best rates if you apply for a home loan. Mortgage rates are at historic lows, so whether you want to buy a home or refinance your existing loan, the lower your DTI the better.
Imagine your current auto loan is at 6%, but your credit union offers a 2.75% interest rate to anyone who wants to refinance. You jump on the deal, knowing your DTI will impress the lender.
Having a low DTI and a high credit score could help you qualify for the best financing rates.
Credit reporting companies do not look at your DTI as they don't record your income. As such, your DTI does not directly impact your credit score. However, if you carry rotating debt -- such as credit cards -- it will affect your credit utilization ratio. This is the second most important factor in calculating your score and it's calculated by dividing the balance you carry by your total credit limits. Generally, it's best to keep your credit utilization below 30%.
Caring about your DTI has a secondary effect: It leads you to carefully monitor how much credit you carry. And the lower your credit card and other rotating debt, the healthier your credit score is likely to be.
There is power in a good night's sleep. DTI may not be as effective as melatonin, but the knowledge you're not carrying a lot of debt and have access to credit can help you rest your mind at night.
If your DTI is too high for comfort, these suggestions can help bring it down:
Like a big toe, DTI may not seem like the most important thing in the world. But, also like a big toe, a low DTI offers balance and stability, two things worth working toward.
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