You’re seriously considering applying for a loan, but you do have debts that you’re able to handle – for the most part. What you should know is that your chances of getting such a loan, or even a credit card, are tied to something called your debt-to-income ratio, which we’ll explore below. So, how much debt is too much? Let’s look.
What is Debt-to-Income (DTI) Ratio?
Debt-to-income ratio is the percentage of your monthly income that goes to bill paying. Such debts typically include mortgage or rent and credit card payments. The lower your DTI, the better.
The two types of DTI are:
- Front-end. This is your housing costs relative to your gross monthly income. If you own your home, this represents your mortgage payment plus mortgage and homeowners’ insurance and property taxes.
- Back-end. This is all your monthly payments – credit cards, student loans, personal loans, etc.
While most lenders use back-end DTI exclusively, mortgage lenders usually use both.
Why is DTI Important?
Not only is it important in determining your eligibility for items such as a loan, credit card, and even an apartment, but your DTI also reveals a lot about how you’re faring financially.
In the main, though, the DTI shows a lender the amount of debt you can reasonably expect to handle.
How is DTI Calculated?
To determine your debt-to-income ratio, all you must do is divide your monthly debt payments by your gross monthly income.
Can My DTI Affect My Credit?
It doesn’t affect it directly because scoring doesn’t factor in earnings. Having said that, your debt load does play a role in your credit utilization rate – a major factor in your credit score. This rate is the total amount you owe on your credit cards divided by your total credit card limits. It’s recommended that you keep this rate under 30 percent.
Your DTI, though, also includes the amount owed on revolving credit lines, installment loans, and other kinds of credit accounts. So, in this way, the more you owe on plastic and other loans, the higher your credit utilization rate. The higher that rate, the more deleteriously it can affect your credit scores.
What is the Ideal DTI Ratio?
While your ratio is merely among other factors lenders such as Achieve and others look at when making their decision – credit scoring and employment are other factors — it is important information, as we say. The higher your ratio, the more risk you pose to lenders who fear you’ll have trouble maintaining payments. To offset the greater risk, a lender may charge you a higher rate. It also may turn you down altogether.
Having said that, the ideal ratio mostly hinges on what it is you’re applying for. Mortgage lenders, for instance, generally seek a front-end debt-to-income ratio of no more than 28 percent (for a Federal Housing Authority loan, the highest you can go is 31 percent). They also generally want to see a back-end ratio of under 43 percent.
In some situations, Freddie Mac and Fannie Mae will permit back-end debt-to-income ratios of 50 percent.
As for other types of loans, you’ll generally need a DTI of no more than 50 percent. That does vary according to the lender, however. So, it behooves you to shop around.
So, how do you know when you have too much debt? Your debt-to-income ratio will tell you. In general, knowing your DTI is a good way to manage your debt load. It’s also good to know your ratio before applying for a loan or credit.