You might borrow money for any number of different needs. A home. A car. A college degree. Yet, in every case, your application must meet certain criteria for approval. As one example, your FICO® score gives lenders a view of your recent track record for repaying debt.
Yet there’s another crucial indicator by which your application is weighed: Your Debt-To-Income (DTI) Ratio.
It’s a straightforward concept. Your DTI ratio measures what percentage of your pre-tax earnings will be committed to the repayment of debt. According to Peter McCarthy, Head of Mortgage Lending for PNC Bank, the DTI ratio is a tool that helps the lender and borrower alike.
“We want borrowers to succeed, not get in over their heads with a loan they cannot afford. That’s why we use the DTI ratio to determine how much exposure a borrower will face when repaying the loan.
“But even before applying for a mortgage or other loan, a smart borrower can look at their DTI ratio to assess their overall financial picture, including how much they can afford to borrow,” says McCarthy.
Lakhbir Lamba, PNC Bank’s Head of Retail Lending, agrees that the DTI ratio can be a valuable tool for consumers, rather than a barrier for applicants to overcome.
“When we look at a credit application, we want to be sure consumers can comfortably handle the additional monthly payments that new debt brings—without being overwhelmed.”
So, harnessing your DTI ratio to assess your overall financial health lets you anticipate the financial road ahead—and whether it’s prudent to take on new debt.
After all, it’s better to understand your current level of debt today, not face the unpleasant surprise of a loan application being turned down.
How Do You Measure Your DTI Ratio?
There are a number of different methods for calculating your DTI ratio, all of which center around your monthly income and how much of that income is needed to meet your financial obligations.
When calculating your DTI ratio, thoroughness counts. Make sure that every monthly debt is factored in, including student loans, credit card payments, insurance payments, and more. Essentially, if it’s a required payment, then it should be part of your calculations.
“It’s important to know how much you can afford,” McCarthy offers. “In the case of a mortgage application, that includes factors such as property taxes, homeowners’ insurance, private mortgage insurance, and flood insurance. You should look at matters holistically, so you can form a realistic picture of what you can afford.”
The industry standard for mortgages is the 28% DTI ratio. It is a simple calculation, based on the premise that your mortgage payment and associated expenses should be less than 28% of your pre-tax income.
Let’s say you earn $8,000 per month before taxes. Multiply $8,000 by 0.28 and, according to this model, your mortgage payment should be less than $2,240.
“The idea behind this calculation is that repaying debt should not take every penny of your income,” McCarthy points out. “Staying within this range allows you to have money for other needs, whether it’s buying furniture, making household repairs, or simply saving for the future.”
While the 28% DTI ratio is the most common guideline for mortgages, it also is important to understand how additional debt such as credit cards, vehicle loans, and student loans affect your overall attractiveness as a borrower. While every borrower’s situation is different, lenders generally prefer to see a total DTI ratio of less than 36%
Want to explore your DTI ratio more fully? PNC has a handy calculator that helps determine what mortgage payment amount you can afford. Just click on the link below and see how valuable learning your DTI ratio can be.
What If My DTI Ratio Is Too High?
Once you determine your Debt-to-Income Ratio, you might find that your financial health is good. But what steps do you take if you find you’re carrying too much debt?
According to Lamba, “Lenders want to ensure that you aren’t overwhelmed by excessive debt. So, this is a good time to look at your overall financial picture and lower existing obligations to a more manageable level.”
If your DTI ratio is too high, here are steps you can take to lower existing debt:
- Create a budget. Look over both your take-home pay and expenses to see where you can cut back. Then, over time, allocate those savings toward debt repayment;
- Prioritize debt payments. Pay off high-interest debts first so they don’t accumulate more interest over time;
- Increase payments. When possible, make larger payments toward your debts. This reduces your principal and shortens the repayment period;
- Consider debt consolidation. When you combine multiple debts into a single loan with a lower interest rate, you can simplify payments and potentially reduce monthly obligations. This also reduces your interest expense; and
- Seek professional advice. Struggling with debt? Sometimes a financial advisor or credit counselor can provide personalized, objective guidance on managing debt effectively.
By following these strategies, you can make progress towards reducing your DTI ratio, often much more quickly than you might think. Not only will you have the peace of mind that comes from reducing debt, but you also can enjoy greater confidence when applying for a loan.
Knowledge is power, as the saying goes. And knowing your DTI ratio can help you achieve greater financial strength in the future.