A quick introduction to the debt-to-income ratio

Do you know your DTI? This lesser-known financial statistic may not get as much attention as emergency funds and credit scores in the financial world, but it’s an important part of your financial history.

Your DTI, which stands for debt-to-income, is a ratio that provides tremendous information about your financial situation. To find out what they are, keep scrolling. Below you will find out what DTI means, why it is important and how to calculate it.

What does the debt-to-income ratio mean?

Your debt-to-income ratio is a financial metric that compares how much you owe in a month versus how much you earn. More specifically, it shows your monthly debt expense as a percentage of your income, so you know how much of your monthly paycheck is earmarked for personal loans and lines of credit.

This simple report provides a quick snapshot of your overall financial health. After all, the higher your percentage, the more your paycheck is tied up by debt.

How do you find out your DTI?

Calculating your DTI is easy. All you have to do is gather all your debt accounts and calculate their monthly payments. Add these payments together. This represents your total expenses for all loans, including mortgages, credit cards, installment loans, and lines of credit.

Next, determine your monthly income Before taxes and other deductibles. Remember to include everything you earn per month. This could include your base salary, as well as commissions, tips, child support, etc.

Now it’s time to do some arithmetic. Take your total debts and divide it by your total gross income. Multiply this number by 100 to get the percentage.

Let’s see the equation in action:

• Let’s say you owe $200 in an installment loan, $300 in student loans, $726 in car payments, and $1,768 on your monthly mortgage. Together, these debts total $2,994.
• The average full-time employee in the United States earns approximately $6,228 per month.

Knowing these figures, you can calculate your DTI like this:

$2,994 ÷ $6,288 = 0.47

0.47 x 100 = 47%

What is a good DTI?

If you have a DTI of 47%, you are higher than most financial advisors recommend. They break this relationship down into three rough categories.

• Well: 0%–35%:
• It needs improvement: 36%–49%:
• Warning: 50% and above

Why do you want to lower your DTI

A high DTI ties up your money, leaving you with less money to spend as you choose. This can lead to serious consequences:

1. Difficulty making ends meet:

Remember, your DTI is not a complete snapshot of all your expenses, only your debts. It does not take into account other essential bills and expenses. This is why a DTI of 50% or more can be a big problem. With half your income going towards loans, you only have the other half of your income to buy everything else. During a cost of living crisis, your debts can make it difficult to make ends meet.

2. Limited financial flexibility

A significant portion of your income being used to pay off debt may mean you can’t save as much. Insufficient emergency savings push countless people to take out more online loans when they can’t afford an unexpected expense.

3. Greater risk of default

With a high DTI, the risk of not being able to pay your bills increases. This can lead to late fees, higher interest rates and, in extreme cases, defaulting on loans.

4. Challenges with credit

Your DTI is not one of the official things that can hurt your score; however, it may interfere with your next loan application. Some lenders may take your DTI ratio into consideration when approving you for loans or lines of credit. If your ratio is too high, these lenders may reject your request for funds.

5. Impact on future financial goals

Saving for long-term goals like homeownership, education, or retirement becomes more challenging when a substantial portion of your income goes toward debt. Debt can also interfere with your ability to invest and grow wealth.

7 Ways to Reduce Your DTI Ratio

Here are seven tips to help you manage your debt load.

1. Create a budget

Making changes to your financial situation is easier when you have a budget. It is both an action plan and a litmus test. By showing you how you spend your money each month, you can prioritize responsible spending habits.

Start by creating a detailed budget that outlines your income, essential expenses, and discretionary expenses. Identify areas where you can cut to allocate more funds for debt repayment.

2. Prioritize debt repayment

Use your budget to find areas where you can cut. Streaming services, subscriptions, takeout, books, concerts, etc. – these are the main areas of savings. Anything you can eliminate or reduce frees up money you can funnel toward debt.

Focus on paying off high-interest revolving debt or your lines of credit and credit cards. These have the potential to accrue interest (and therefore increase in size) the longer you have them.

3. Increase income

Let’s face it: sometimes you can’t get blood from a stone. In other words, you can’t free up money by cutting out takeout if you never get it to begin with. For those on smaller budgets, you may need to think about the other side of the DTI equation: your income.

Look for opportunities to increase your income, such as taking a part-time job, freelancing, or exploring side hustles. Whatever you earn from these extra jobs can go directly towards your debt.

4. Refinance or consolidate loans

Paying off debt can be difficult when you have many high-interest loans that add interest to what you owe each month. In some cases, you may be able to reduce your interest accrual through refinancing. By consolidating your debt into one loan, you may be able to lower your interest rate and consolidate your payments into one.

Be sure to test a consolidation loan in a loan payment calculator before agreeing to anything. You don’t want to get around your debt if you get nothing out of it or, worse, agree to terms that are actually harder to pay.

6. Talk to a debt counselor

If you’re having trouble balancing your budget, find a debt counseling program. Many debt organizations provide free consultations, giving you professional advice on how to manage your debt.

7. Avoid taking on new debt

When you work hard to lower your DTI, you don’t want to ruin your efforts by adding what you have to. Try to avoid taking out new loans or lines of credit whenever possible. Delay large purchases and use your budget to focus on emergency savings. These savings replace the safety net of loans in unexpected expenses.

Bottom line:

Consider your DTI a key performance indicator for your finances. Too high and this ratio indicates that you may be experiencing problems, if you haven’t already.

So, what are you waiting for? Follow the instructions above and discover your ratio.

If your score is above 36%, learn how to pay off your debts quickly.

What happens if you are below this benchmark? You may still want to try the tips shared here today. Anyone who has debt should know how he intends to repay what he owes. Eliminating monthly debt payments frees up money for the things you really want to buy.