Many lenders will consider your debt to income ratio when you apply for a personal loan as a way of gauging your ability of taking on new debt and the likelihood that you will be able to keep up with any loan payments. Understanding what a debt to income ratio is and how to calculate it is much easier than many might assume.
A debt-to-income ratio is the percentage of a consumer’s monthly gross income that goes toward servicing debts. Another way to put that would be all your monthly debt payments divided by your gross monthly income (pre-tax).
What is a Good Debt to Income Ratio
When thinking of applying for a personal loan, it can pay to prepare. Determining your debt to income (DTI) ratio beforehand might be beneficial if you are considering to pursue a personal loan with bad credit in the future.
To make it easy to follow, let’s paint a picture to make it easier to follow. As an example, let’s assume that you had a mortgage of $1,200 each month, along with a car payment of $500, and another $300 in monthly student loan debt. This amount comes to $2,000 each month in debt. Now if your gross income (the amount before taxes and deductions) each month was $8,000, then your debt to income ratio would be 25%.
If you are wondering what a good debt to income ratio is when applying for personal loans, many experts say that when related to personal loans, being below 35% is advised.
But the truth is, the maximum DTI ratio can vary from lender to lender but a DTI that is high will definitely increase the lender’s risk in making the loan so your interest rate will likely increase.
How to Calculate Debt to Income Ratio
If wondering how to figure debt to income ratio, you’ve come to the right place. To answer that, we’ll provide a simple example to show you how to calculate debt to income ratio for yourself to see how it works with your credit score.
Suppose that you have 2 credit cards with a combined credit limit of $10,000. Now if you owed about $3,000 on one card and $2,000 on the other, you would owe a total of $5,000. That means that your debt to credit ratio (or credit utilization ratio) would be 50 percent.
When looking to calculate debt to income ratio for yourself, you want to start by adding up all regular debt payments that you make each month. This might include rent or mortgage, along with student loans, credit card bills, alimony, car payments, child support and other similar debts, including property taxes and insurance. This should not include expenses like your electricity bill, gas or groceries. Once you have your debt added up, this total divided by your gross monthly earnings would be your debt to income ratio.
What Other Factors Affect My Personal Loan Application?
While your debt to income (DTI) ratio is one factor that can affect your credit score, and ability to get approved for a personal loan, there are several other factors that are considered besides your credit score. Things like your payment history, how many credit accounts you’ve opened recently, the length of your credit history, along with the types of credit accounts you have are all considered by lenders in their decision to extend credit to a borrower.
While your debt to income ratio does not affect your credit score, it is looked at be lenders when applying for a personal loan when reviewing your loan application as it tells part of the story to your creditworthiness, what kind of risk you might be, and the likelihood of you being able to repay any personal loans you might borrow
A low DTI ratio indicates sufficient income that is relative to debt servicing and makes an applicant more attractive to most lenders since they have a higher degree of confidence in the borrowers ability to make their payments and repay the loan.
How Can I Lower My DTI?
The most obvious would be to increase your income. Easier said than done, we’ll look at some other possibilities that might be more useful. You could also increase the monthly amount that you pay towards your debt to reduce the amount, along with the DTI ratio.
When determining what debt to pay off first, you might look at the ‘bill-to-balance’ ratio. Let’s say that you owe $200 on Credit Card A and $100 on Credit Card B. Card A’s monthly payment is $40 and Card B’s is $50. By targeting Card B first, since the monthly payment represents 50% of its balance, whereas Card A’s monthly payment would only make up 20%, you could improve your DTI faster.
Another way would be if you were to transfer your balances from any high-interest rate credit cards over to a low-interest credit card, you would find that the amount of your monthly payments would decrease. At the same time, you would also find that your total monthly debt payments and your DTI ratio would decrease. But it’s worth clarifying that your outstanding debt would remain unchanged.
Of course if you are to avoid taking on more debt while trying to pay it down it is certainly going to help you at least maintain where you are rather than increase your debt. You could also look at refinancing, and restructure your debt with a new lender.