Managing your money is a constant ebb and flow—funds coming in such as salary and passive income from investments; cash going out like credit card, loan and mortgage repayments. Finding the balance between earnings and monthly expenses is key to maintaining healthy finances and a good credit score.
That balance hinges on your debt-to-income (DTI) ratio.
What is debt-to-income ratio?
Your debt-to-income ratio is, quite simply, a percentage that compares the two factors within its name:
- Debt: Your total monthly debt payment across all lines of credit and accounts.
- Income: Your gross monthly income from all sources.
By comparing how much money you have to spend each month with how much money you make each month, the figure predicts your financial standing and your likelihood to make prompt repayments on current and future debts.
How is debt-to-income calculated?
Debt and credit might not be the most straightforward subject, but the mathematical formula for debt-to-income is pretty simple.
Here’s to figure out how debt-to-income:
All of your monthly debt payments
Your gross monthly income
That equation will leave you with a percentage that essentially indicates how much of your gross income has to be put towards debt repayment each month.
Let’s run some numbers to get an idea of what this looks like in practice:
Masha has four monthly debt payments:
- Mortgage: $1,000
- Student loan: $300
- Car loan: $550
- Credit cards: $450
Masha’s total debt is $2,300. Her gross monthly salary is $7,000.
2,300 ÷ 7,000 = 0.32857 x 100 = 32.86
Based on our debt-to-income ratio calculator, Masha has a DTI of about 33%.
A 33% ratio is considered fairly reasonable. The higher the percentage, the more likely lenders are to assume you won’t be able to make your payments. That’s based on an assumption of how much the average person can afford to allocate towards debt repayments on top of other expenses.
Understandably, most people can’t put 70% of their monthly income towards debt repayment. More likely, they’d be able to pay a percentage closer to 30% or 40%. Everyone’s situation varies, but certain debt-to-income thresholds are used as standard rules to dictate responsible financial behavior.
What are the debt-to-income rules?
There are no hard and fast rules on how to spend and save. Still, there are a few general debt-to-income ratio guidelines that will help you practice sustainable spending and qualify for potential loans when the time comes.
The 43% Rule
After studying mortgage loans and their repayment rates, experts noticed that higher debt-to-income ratios indicated a lower likelihood of making consistent, long-term payments. A DTI of 43% became the maximum allowable ratio to secure a Qualified Mortgage—hence, the 43% rule was born.
A Qualified Mortgage offers more stable conditions that aid the borrower in making consistent payments. But to qualify for a Qualified Mortgage, the lender has to confirm that you meet the “ability-to-repay” rule; this is a good-faith determination that you’ll be able to make regular payments based on your creditworthiness (including your debt-to-income ratio).
If you don’t meet the 43% rule, there are still exceptions that may allow you to secure a mortgage:
- A small lender with fewer than $2 billion in assets and less than 500 mortgages in the previous year may still be able to offer you a Qualified Mortgage.
- A standard lender may offer you a non-Qualified Mortgage if they determine in good faith that you should still be able to repay your loan on time.
For aspiring homeowners, the 43% rule gives you something to strive for as you calculate your finances each month.
The 28/36 Rule
While mortgage lenders dictate the 43% rule, the 28/36 rule is more of a self-imposed goal for fiscally responsible homeowners.
This two-part rule suggests that:
- No more than 28% of your gross monthly income should go towards household expenses (your PITI: principal, interest, taxes, and insurance).
- No more than 36% of your gross monthly income should go towards all of your monthly debts combined, including the 28% towards household expenses.
For most individuals and families, housing is likely the largest expense each month. Hopefully, your remaining monthly debts (car payments, student loan payments, personal loans, credit cards, etc.) will only add up to an additional 8%.
The 28/36 rule is helpful in two distinct ways:
- Guiding your house hunt. It urges homeowners to find a price tag that yields a mortgage payment they can reasonably afford.
- Formulating your debt repayment strategy. It reinforces the drive to pay off other debts to keep the overall number low.
How to lower your debt-to-income ratio
A ratio is a relationship between two numbers—you can change it by adjusting the numerator (in this case, your debt) or the denominator (your income).
It’s a bit more challenging to raise your monthly or annual income at the drop of a hat, though you can always take on side jobs and passion projects to supplement your salary. Aside from that, there are many ways to lower your debt payments over time:
- Making larger-than-minimum payments towards your biggest debts. A tough pill to swallow up front but a major relief down the road, increasing your debt payments gives you a shortcut to a lower DTI ratio.
- Saving up for large purchases to pay more upfront and take on less debt. If you can afford a bigger down payment on a sizable purchase like a home, car or business property, you’ll be left with a smaller monthly loan payment. It takes time to save up the necessary cash, but it’ll set you up for success in the following years.
- Postponing taking out additional debt. Similarly, hold off on big purchases and new lines of credit until you’ve paid down more of your existing debt. Once you’ve made a sizable dent, you can consider taking on more debt for essential purchases.
- Monitoring your progress carefully. Recalculate your DTI ratio each month to chart any changes—good or bad. If you’re not making progress month over month, it might be time for more consequential lifestyle changes.
Tally: your personalized debt manager
Sometimes, a comprehensive spreadsheet and an endless budgeting-induced headache can only get you so far. You might need a personalized advisor to help you pay off your debts in the most efficient and effective way possible.
Tally is your dedicated robot expert, designed to help you reach your financial goals and emerge debt-free.
That mounting pile of debt may look daunting from this angle, but once your Tally Advisor shows you the best technique to chip away at it, you’ll see that it’s not an unscalable mountain after all—it’s more like a small mound.
And you can handle a small mound.