Your credit score isn’t all that is important. Here’s another key number that lenders are looking at
With all the attention credit scores get, it’s natural to think that good credit means you’re ready. Many consumers have made this mistake and then were surprised after being turned down for a loan or mortgage.
While your credit score plays an important role in loan decisions, it’s not the only thing that matters. Lenders also look at your debt-to-income ratio (DTI). Mortgage lenders have even chosen the DTI ratio, and not an applicant’s credit rating, as the factor most likely to make them reluctant to finance a loan application.
Before applying for a loan, it is important to understand how this metric works and what constitutes a good DTI ratio.
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What is a DTI ratio?
Your DTI ratio is the amount of your gross monthly income that you need to spend on debt repayment. To calculate this, divide your monthly debt payments (your credit card payments, car loan, mortgage, and any other debt you have) by your gross monthly income.
For example, let’s say your gross monthly income is $ 3,000. You have $ 200 in credit card payments and an auto loan payment of $ 400, for a total of $ 600. Your DTI ratio would be $ 600 divided by $ 3,000, or 20%.
Assess your DTI ratio
Each lender has their own DTI ratio standards. However, if you want to get a feel for where yours is and if you need to work on it, Wells Fargo has a solid set of guidelines:
- 35% or less: This is considered a stable DTI range. You should have money left over after paying your bills, and you could probably qualify for loans and credit cards.
- 36% to 49%: Your DTI ratio is manageable, but there is room for improvement. You may want to work on reducing it, especially if you plan to apply for a loan or line of credit soon.
- 50% or more: Debt payments eat up a substantial portion of your income, and it would be difficult to get approval for any new credit application. Paying off debt is a smart financial priority to freeing up more money each month.
It is a little more complicated if you are applying for a mortgage. Mortgage lenders consider two types of DTI ratio, and each takes into account what your DTI ratio will be after you add your projected housing costs.
The first is your initial DTI ratio, which is the share of your gross income spent on housing costs. An initial DTI ratio of 28% or less will give you a higher chance of approval.
The second is your back-end DTI ratio, which is the portion of your gross income that will go towards all debt repayments, including your housing costs. A back-end DTI ratio of 36% or less is recommended, although it may be possible to get approval if yours is higher.
Why Your DTI Ratio Matters to Lenders
Lenders take a close look at your DTI ratio because it is a strong indicator of your financial stability and, therefore, the likelihood that you will pay back what you borrow.
A high DTI ratio could mean that you are already running out of steam with your monthly payments. If you spend 50% or more of your gross income on debt, lenders will be reluctant to approve you for anything. A low DTI ratio, on the other hand, signals that you don’t have too much to do and that you are a good candidate for a loan.
Lenders cannot get this information from your credit score. There is a factor in your credit score, your credit utilization rate, which is similar to your DTI ratio. But it depends on how much you owe on your credit cards compared to your total credit amount. Since it doesn’t factor in your income, it doesn’t give lenders a clear picture of how your monthly payment obligations stack up against your income.
How to lower your DTI ratio
If your DTI ratio is higher than you would like, it’s a good idea to work on improving it.
One way to do this is to increase your income. But if your problem is that your DTI ratio disqualifies you from a mortgage or other type of loan, this method won’t help you right away. Lenders usually don’t count the income you just started earning in your DTI ratio.
Instead, you will need to focus on reducing your monthly debt payments. And for most people, that’s a more realistic solution than increasing income.
Here are some tips for reducing those monthly obligations:
- Review your spending habits over the past few months. Find places to cut back so you can spend more money on your debt.
- Favor credit card repayments rather than installment loans. Paying off credit cards reduces your monthly payment amount. With installment loans, the amount of the monthly payment usually stays the same. Until you pay off the entire loan, your DTI ratio will not drop.
- Look for debt consolidation options that lower your monthly payments and lower your interest rate. Credit cards with balance transfer are a popular choice because they offer an introductory APR of 0%. You can also check out debt consolidation loans.
- Don’t add to your debt. The only time you should apply for a new credit card or loan is if it’s for debt consolidation.
Tracking your credit is a smart financial habit. Since your DTI ratio is just as important, be sure to track it as well. By maintaining a low DTI ratio, you will be less likely to have money problems and more likely to be approved when applying for a loan.