How to Reduce Your Debt-to-Income Ratio

Regularly reviewing your finances could help you manage your expenses and work toward your goals. Part of that review might be checking your bank account for unauthorized charges, making sure your bills are all paid, and looking at your credit score periodically. 

Even so, you may not have a complete picture of your finances if you aren’t reviewing your debt-to-income (DTI) ratio along with these other factors.

So, what debt-to-income ratio should you aim for? Generally, when it comes to your DTI, the lower, the better. A high debt-to-income ratio could make it harder to get a loan. And it could also be a warning sign that your overall credit health—and your credit score—may be heading downhill.

A lower DTI likely shows that you can afford the amount of debt you have, and could have room in your budget for new financial priorities. 

Monitoring your DTI, especially if you’re navigating debt relief, could provide an early signal that you need to cut back on expenses or manage your debt differently. That’s why it’s important to keep track of your debt-to-income ratio, understand how to calculate it, and know how to reduce it.

Freedom Debt Relief isn't a credit repair organization and doesn't provide or offer services or advice to repair, modify, or improve your credit. 

What Is a Debt-to-Income Ratio?

Your debt-to-income ratio is the percentage of your total monthly income that goes toward paying your debts. Lenders use DTI to understand how much your current debt impacts your finances, helping them figure out how much additional debt you can afford.

If a lender thinks your debt-to-income ratio is too high, they may consider you a borrowing risk and not lend to you. On the other hand, you may get approved for a loan or mortgage more easily if you have a lower debt-to-income ratio. Your creditors may feel confident that you’ll pay back your loan, since your money isn’t already tied up in other debts.

Unless you’re making a major purchase that adds to your debt, your goal should typically be to keep your debt-to-income ratio as low as possible. This frees up more money in your budget for other spending, and could make it easier to save toward long-term goals. 

Your DTI includes all monthly debt payments, including:

• Mortgage payments

• Loan payments

• Credit card payments

It does not, however, include your regular household bills like groceries. 

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What’s the Difference Between Debt-to-Income Ratio and Credit Score?

DTI and credit score are two factors that most lenders consider when you apply for credit. Either one could be a deal-breaker when you apply for a new credit account.

Your credit score helps lenders decide whether to lend to you. If it’s a “yes,” your credit score helps them decide what terms to offer. If you have a lower credit score, you may have a hard time getting a low interest rate on a loan.

Your credit score really matters when you’re looking to take out a new line of credit, like a loan or mortgage. Your payment history, credit utilization, and credit history are all important credit score factors. Your score helps creditors determine the likelihood that you’ll pay back the loan (referred to as your creditworthiness). 

Your DTI helps creditors decide how much to lend to you.

Debt-to-income ratio helps creditors know if you have room in your budget for a new payment. 

How Do You Calculate Debt-to-Income Ratio?

You don’t need fancy tools to calculate your debt-to-income ratio. Simply add up all of your monthly debt payments first. Then, divide that total number by your gross monthly income (your income before taxes). Finally, multiply that number by 100 to get the percentage of debt to income.

In mathematical terms, this is how to calculate debt-to-income ratio:

([Total Debt Payments] / [Gross Income]) x 100 = [Debt-to-income ratio]

When calculating DTI, some common debt categories to include are:

• Mortgage payments

• Personal loans

• Auto loans

• Student loans

• Credit card payments

Meanwhile, your income may consist of more than just your salary. In addition to your regular paycheck, your income might include:

• Earnings from a side job

• Alimony

• Child support

• Investment income, such as from a rental property

Let’s run through an example so you can see exactly how DTI is calculated. 

Let's say you have these monthly debts:

• $1,000 mortgage payment

• $400 car payment

• $200 student loan payment

• $100 credit card payment

And let's say your gross monthly income is $4,500.

To calculate DTI, here's how we run the numbers:

($1,000 + $400 + $200 + 100) / $4,500 x 100 = 37.77%

Here are some expenses you should not include in your debt-to-income ratio calculation:

• Utility bills

• Groceries

• Gas

• Taxes

• Clothing

• Entertainment

While these may be things you spend money on every month, they are not debts. Your debt-to-income ratio should only include money you are contractually obligated to repay on a monthly basis. 

DTI Calculation Mistakes to Avoid

It’s important to have a good handle on your DTI so you know how much more debt you can afford, and so you don’t get in over your head. Here are some mistakes to avoid in the course of calculating your debt-to-income ratio.

Using net income instead of gross income

When calculating DTI, use your gross income, which is your income before taxes and other deductions. Using your net income will result in a higher DTI.

Forgetting about some of your debts

Your DTI needs to account for every debt payment you're on the hook for each month. Comb through your bank statements to create a list of your monthly payees so you don't forget any.

Including non-debt expenses in your number

Your DTI only needs to include debts. Don't include groceries, gas for your car, or expenses that are not debt payments.

Miscalculating your housing costs

You may be inclined to just include your mortgage’s principal and interest as part of your DTI. That number, however, should include all of the costs that go into your monthly payments, including property taxes, homeowners insurance, and HOA fees, if you have to pay them.

Forgetting about side income

You may get most of your monthly income from your regular job but have another job you do on the side. You can count your gross income from that side job toward your DTI. Forgetting to include income could result in a higher DTI than what you actually have.

What Is a Good Debt-To-Income Ratio?

Every lender has slightly different criteria with regard to DTI. Here’s a general breakdown of what’s considered more versus less favorable.

• Below 36%: Most lenders will consider you for a new mortgage or loan, because you don’t have a large amount of debt relative to your income.

• Between 37% and 54%: Some creditors may consider you a credit risk, but might lend to you anyway.

• Above 55%: You may have trouble getting approved for a loan, but it’s not impossible. 

If you plan to apply for a mortgage or other large loan, it’s a good idea to try to reduce your DTI first. 

DTI Requirements by Loan Type

Before you apply for a loan, it can be helpful to know what DTI requirements you may be looking at. Here’s an overview, but do understand that in many cases, lenders look at more than just DTI when making their decisions.

Conventional mortgages

With a conventional mortgage, lenders might look at a DTI of 36% as an ideal to strive for—but that doesn’t mean you won’t get approved with a higher DTI. Conventional mortgage borrowers can often qualify with a DTI of up to 45%, or up to 50% with an automated underwriting system. Ultimately, each lender can decide what maximum DTI it’s comfortable with while taking other factors into account, like credit score and the amount of your down payment.

FHA loans

With an FHA loan, you may be able to get approved for a mortgage with a DTI of up to 57%. But most mortgage lenders want to see a lower DTI than that. As with a conventional mortgage, other factors like your credit score and down payment will also be taken into account.

Personal and auto loans

Personal loans are unsecured, which means they are not tied to any specific asset. Because personal loan lenders take on a lot of risk, they tend to have strict DTI requirements. Some personal loan lenders will allow a DTI of up to 50%, but you may need a certain (high) income for a lender to feel comfortable writing you a loan with that DTI.

Similarly, you may be able to get an auto loan with a DTI of 50%. But some lenders may require a lower DTI, depending on your income and credit score.

What Does Your Debt-to-Income Ratio Say About Your Financial Well-Being?

Your debt-to-income ratio speaks to your general financial well-being.

Having a higher debt-to-income ratio, for example, could mean that you don’t have money left over to save each month. You’re spending most of your income on your debt. Having a lower debt-to-income ratio, on the other hand, may indicate that you’ve taken on expenses you can comfortably afford.

That said, a low DTI isn’t automatically a sign of financial health.

The DTI calculation only accounts for your minimum monthly credit card payments on your various accounts. If you have large balances but low minimum payments, it’s possible to have a low DTI even if you’re deeply in debt. It’s also possible to have a favorable DTI but a less favorable credit score. Large credit card balances are notorious for dragging credit scores down. 

When Should I Be Concerned About My DTI?

You should be concerned about your DTI when your debts are difficult to keep up with, and when they’re preventing you from meeting other big goals. If you suffer a sudden financial hardship—like a job loss or illness—you may not have the funds you need to cover your debts.

Even one missed debt payment could negatively affect your credit score and trigger a higher APR, making it harder to pay your bills, and causing you to miss more payments. If you’re worried that your debt-to-income ratio is too high, there are solutions that could help you reduce it.

How Can You Reduce Your Debt-to-Income Ratio?

If you want to reduce your debt-to-income ratio, you need to reduce your debt, increase your income, or do both at the same time. Let’s review different options for lowering your DTI. 

Pay more than your credit card minimums

Credit card companies allow you to make minimum payments on your balances each month. That may help you from a cash flow perspective, but it could cause your balances to linger and grow as interest is added on.

A good way to reduce your debt-to-income ratio is to make more than your minimum payments on credit cards so that your balances shrink and eventually are paid down completely. There are a couple of strategies you could use for paying off credit card debt. 

One is the snowball method, where you pay off your credit cards in order of smallest balance to largest balance, regardless of the interest rate. Another is the avalanche method, where you pay off your credit cards in order of highest interest rate to lowest, regardless of the balance.

Some people find the snowball method easier because in tackling smaller balances first, you tend to see results sooner. The avalanche method, however, could save you more money on interest as you're working to pay off your debt.

Refinance your loans

When you refinance a loan, whether it’s a personal loan, mortgage, or auto loan, you replace an existing loan with a new one—typically with more favorable terms. Refinancing your existing loans could mean locking in a lower interest rate, which, in turn, could result in smaller monthly payments and a lower DTI.

In some cases, refinancing a loan could mean extending your repayment period. This, too, could reduce your monthly payments because you’re getting more time to pay off your debt, resulting in a lower DTI. However, this method may not save you money on interest. It could actually leave you paying more interest on your debt over time.

Consolidate your debt

If you're juggling multiple credit card balances or a few high-interest loans, a debt consolidation loan could be a way to not only lower your monthly payments, but also reduce your debt-to-income ratio. And as an added benefit, a debt consolidation loan might also simplify your finances by giving you fewer individual monthly payments to keep track of.

Some options for consolidation loans include personal loans and home equity loans. You could also consider a cash-out refinance to consolidate debt. 

If you’re having a hard time making minimum payments each month and can’t qualify for a debt consolidation loan, another option may be a debt settlement program. This involves negotiating with creditors to forgive some of your debt. You can negotiate debts on your own, or work with a professional debt settlement company. 

Debt experts at a reputable company should have relationships with your creditors and knowledge of how the debt settlement process works, potentially leading to better outcomes. All told, professional debt relief services could help reduce the amount of debt you have, leading to a lower debt-to-income ratio. 

Make extra loan payments beyond what you need to pay each month

Just as making more than your minimum credit card payments each month could reduce your debt and DTI, so too can making extra payments on other loans. However, before you make extra loan payments, it’s best to whittle your credit card balances down to $0 and then focus on debts like personal and auto loans. 

The reason is twofold. First, your credit cards likely have a much higher interest rate than your other loans. But also, reducing your credit card balances tends to have a direct positive impact on your credit score. 

Paying an installment loan like a personal or home equity loan on time could help your credit score, too. But paying down their balances won’t necessarily lead to a higher credit score, even though it could reduce your DTI.

Boost your income with a second job or overtime

Boosting your income is an effective way to reduce your debt-to-income ratio. But it’s not an easy thing to march into your boss’s office and demand a raise. 

This doesn’t mean you can’t and shouldn’t try. But a more effective way to earn more money may be to get yourself a second job or side hustle in the gig economy. Another option may be to pick up overtime shifts at your main job if you’re eligible for extra pay. 

Take Control of Your DTI and Your Financial Future

If you’re not happy with your debt-to-income ratio, it’s time to take action. Freedom Debt Relief can help you understand your options, including our debt settlement program. Our Certified Debt Consultants can work to help you find a solution that will help you decrease your DTI and put you on the path to a better financial future. Find out if you qualify right now.