Understanding Debt-to-Income Ratio

The debt-to-income ratio is one of several factors that contribute to overall financial wellness. It compares your monthly debt payments to your gross monthly income. This ratio is significant because it can help you find peace of mind with your finances and make smart decisions when making big life decisions.

In this Tower Loan guide, you’ll learn how to calculate debt-to-income ratio and when it is important to make this calculation. We’ll also discuss what is a good debt-to-income ratio, how to lower yours, and how it impacts approvals when applying for a personal loan.

What Is Debt-to-Income Ratio?

Before diving into the math of how to calculate debt-to-income ratio (DTI), let’s explore what this ratio means and its two components.

A debt-to-income ratio demonstrates how much money you make each month goes toward your debts. It’s the percentage you get when you divide your monthly debts by your gross monthly income.

The first component of DTI is the front-end ratio, which is your housing-related expenses versus your income. The second component is the back-end ratio, which is all your monthly debts compared to your income. Both components are important because lenders look at each one when reviewing and approving loan applications.

How to Calculate Your DTI Ratio (Step-by-Step Guide)

At this point, you might wonder, “What is my debt-to-income ratio, and how can I arrive at an accurate percentage based on my personal finances?”

To calculate debt-to-income ratio, simply follow these three steps.

Step 1: Add Up Your Monthly Debt Payments

Consider all payments that you are obliged to make each month, including recurring expenses related to where you live, money you’ve borrowed, and how you support yourself. These expenses must be the same amount each month without fluctuations.

Here are examples of monthly debt payments to include in this step:

• Mortgage
• Homeowners’ association fees
• Property taxes
• Homeowners’ insurance
• Rent
• Auto loans
• Personal loans
• Student loans
• Minimum credit card payments
• Alimony
• Child support
• Any other fixed monthly debts

However, you should not include variable expenses that change amounts from month to month, such as grocery costs, utility bills, or entertainment fees.

Step 2: Determine Your Gross Monthly Income (Before Taxes)

Step two in how to figure out debt-to-income ratio is to calculate your gross monthly income before taxes are taken out. This figure should be the total amount of money you bring in before any fees are removed or deductions are taken.

Here are some examples of what to include in your gross monthly income:

• Salary from your job
• Side income from gig work
• Rental income
• Investment income
• Bonuses
• Commissions
• Tips
• Overtime pay
• Freelance income
• Self-employed business income
• Child support received
• Social Security payments received

Step 3: Divide Total Monthly Debt by Gross Monthly Income

The last step to calculate debt-to-income ratio is to divide your total monthly debt (step one result) by your gross monthly income (step two result). Then, multiply this figure by 100 to get your DTI percentage.

Example Calculation

Here’s a real-world example of how to calculate debt-to-income ratio to help you understand how the math works.

Example monthly debts:

• $1,500 mortgage
• $500 car loan
• $300 student loan
• $50 minimum credit card payment
• Total = $2,350

Example gross monthly income:

• $5,000 monthly salary 
• $500 monthly gig work income
• $200 monthly child support received
• Total = $5,700

Example DTI ratio:

• Divide $2,350 monthly debt by $5,700 gross monthly income = 0.412
• 0.412 multiplied by 100 to get a percentage = 41.2%
• Therefore, the DTI is 41.2%

What Your DTI Ratio Means

Your debt-to-income ratio is significant because lenders place DTI percentages into categories to rank your creditworthiness.

So, what is a good debt-to-income ratio?

In our example above, the person with a 41.2% DTI would just barely fall into the “good” category, meaning they are in a reasonable position to secure a loan but could make financial improvements to improve their chances and get the best rates.

Take a moment to calculate your own debt-to-income ratio and see where you fall within these categories:

• DTI below 35%: Excellent – Low risk to lenders
• DTI Between 36%-41%: Good – Manageable debt, but improving it may help
• DTI Between 42%-50%: Caution – Loan approvals might be harder
• DTI Above 50%: High risk – Difficult to get new credit, may indicate financial strain

How DTI Affects Loan Approvals

Although these categories provide general guidelines of where lenders may assess your financial situation, different lenders set their own unique DTI limits. There are also certain debt-to-income ratio requirements for different loan types.

For example, with some exceptions, the maximum back-end DTI for a convention loan is about 45% to 50%. FHA loans can go up to 50%, and VA loans may go above 50%. However, USDA loans only go up to about 44%.

Lenders generally prefer DTI ratios of less than 36%, but the upper cutoff can go up to 50%. This range applies to personal loans, auto loans, and credit cards. An exception may apply if you have a high DTI but a strong credit score to balance it out.

How to Lower Your DTI Ratio

If you have a DTI ratio between 36% and 41%, you likely still have a good chance of getting the loan you need with competitive rates.

However, suppose your debt-to-income ratio is more than 41%. In that case, it may be time to look into ways to reduce your DTI ratio to give yourself greater financial flexibility and stability.

Reduce Debt

If you want to work toward a good debt-to-income ratio, one effective strategy is to reduce your overall debt. You can do this by paying off high-interest credit cards faster to have less debt burden contributing to your ratio.

You can also look into debt consolidation loans to lower monthly installments. It may also be worth contacting your lenders to refinance or negotiate lower interest rates.

Increase Income

Another way to lower your DTI ratio is to boost your monthly income. For example, you might ask for a raise at your current job or offer to work overtime for additional pay. You could look for a second job or pick up side gig work doing odd jobs to make extra money.

Some people have found success starting a side-hustle business that is both a passion project and an additional income stream. You might also find success with passive income opportunities, such as creating and selling online courses, affiliate marketing, selling digital products, or renting out real estate property you own.

Smart Budgeting Tips

Once you calculate debt-to-income ratio and have a good idea of where your percentage falls in potential lenders’ eyes, you can improve your budget and manage your money responsibly.

The first step in smart budgeting is to track all of your large and small expenses to identify and distinguish essential versus non-essential spending. You might be surprised at where your money is actually going each month because little costs add up and impact your overall financial health over time.

Whenever you come into a rare or unexpected influx of cash, consider using that money to pay down debt instead of splurging on something you don’t truly need. When your tax refunds roll in or you get a bonus at work, use that money to improve your debt-to-income ratio for a more stable financial future and greater potential purchasing power in the years to come.

Final Thoughts About How to Determine Debt to Income Ratio

From our financial experts at Tower Loan, we hope you now know how to calculate debt-to-income ratio and understand why it’s important to do this calculation periodically to assess your financial situation.

Maintaining a low DTI can help improve your financial stability and borrowing power. However, it is only one of several crucial factors in securing a loan and shaping the way lenders view you when you need to borrow money quickly and urgently. Regularly check and manage your DTI to stay in control of your debt and be prepared for lender decisions whenever it’s time to take out a loan.

If you have additional questions about how to figure out debt-to-income ratio or general financial questions, Tower Loan is here for you.

Our online loans are the fastest way to borrow money when you need it most. However, we have many branch locations staffed with friendly and knowledgeable financial professionals to walk you through the application process and answer all your questions.

We also welcome you to check out our other blog articles to learn about financial topics that matter to you.