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Before approving you for new credit, lenders will likely first look at your credit report, your credit score, and something called a debt-to-income ratio, commonly known as DTI.
While all of these factors help show your likelihood of repaying the money you borrowed, your DTI shows whether or not you have the means to repay. As expressed, a “debt-to-income” ratio is the amount of debt you have relative to your income.
Lenders look at your DTI to see how much of your monthly income goes towards debt obligations you already have. A low DTI indicates that you earn more than you owe, while a high DTI means that more of your pay goes toward paying your debts.
How to calculate your debt-to-income ratio
To calculate your DTI, divide your total monthly payments (credit card bills, rent or mortgage, car loan, student loan) by your gross monthly income (what you earn each month before taxes and any other deductions).
For example, this is what your monthly payments might look like:
Mortgage: $ 1,500
Car loan: $ 500
Student loan: $ 320
Minimum payment by credit card: $ 180
Total monthly bill payments: $ 2,500
If your monthly debts are $ 2,500 and your gross monthly income is $ 5,000, your DTI calculation would look like this: $ 2,500 / $ 5,000 = 0.5. To get the proportion as a percentage, you would multiply 0.5 x 100 = 50%. Your DTI would be 50%.
The ideal DTI varies depending on the lender, the type of loan, and the size of the loan. Typically, a DTI of 20% or less is considered low, and 43% or less is the general rule of thumb for obtaining a qualified mortgage, according to the CFPB. Personal loan lenders tend to be more forgiving of DTI than mortgage lenders. In all cases, however, the lower your DTI, the better. A lower DTI shows that you are earning more than you owe and therefore you can afford to take on more debt while keeping up with the monthly payments you already have.
How to improve your debt-to-income ratio and help your credit score
Your income is not included on your credit report, but lenders will often ask you to include it in any loan application, as well as to show proof of income.
Since your DTI does not appear on your credit report, it will not necessarily affect your credit. However, the actions you take to lower your DTI can, in turn, help your credit score.
An obvious way to reduce your DTI is to reduce your overall debt burden. If you can, pay off your credit card balances or any other loan, or at least eliminate balances when possible. Getting rid of outstanding credit card debt also helps lower your credit utilization rate, which looks at the amount of available credit you use. A low utilization rate is essential for a good credit score and makes up 30% of your score calculation.
A debt consolidation loan could make it easier for you to reduce your debt faster by streamlining your monthly credit card payments on a single bill. Qualifying for a lower monthly payment can also help lower your monthly debt obligations and therefore lower your DTI. We rate the Marcus by Goldman Sachs Personal Loan as the best for debt consolidation for not offering origination fees, early settlement fees, and late fees.
Keep track of your credit score as your debt-to-income ratio improves
Since your credit score plays an important role in whether or not new credit is approved, keeping a record is just as important as working to improve your DTI.
Credit monitoring services help you stay alert to any changes in your credit by notifying you in real time, as well as helping you detect fraud early on. CreditWise® from Capital One is a free credit monitoring service that is open to anyone, regardless of their Capital One cardholder. It also offers dark web scanning and social security number tracking, plus a credit score simulation tool. As you plan to pay off any debt in hopes of improving your DTI, you can see how these efforts help your credit score, too.
Increasing your income is another way to improve your DTI. Consider asking for a raise at work, looking for additional work that you can do in the evenings or on weekends, or leaving your job for one that pays you more.
Keep in mind that when you are approved for that new loan you wanted, your DTI will go up as you will go into more debt. This can affect your ability to get more loans in the future.
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Editorial note: The opinions, analyzes, reviews or recommendations expressed in this article are solely those of the editorial staff of CNBC Select and have not been reviewed, approved or endorsed by any third party.