How to calculate debt-to-income ratio

If you have any debt, you've probably heard the term "debt-to-income ratio" (DTI) a few times. But what does it really mean?

The truth is, your debt-to-income ratio is an important number—one that affects everything from loan eligibility to the amount of money in your pockets each month.

Ready to decipher DTIs once and for all? Keep reading for everything you need to know about debt-to-income ratios.

What is a debt-to-income ratio?

Basically, a debt-to-income ratio expresses the amount of your income that goes toward paying back debt. It's calculated as a percentage of your monthly earnings—find your DTI, and you'll know exactly how much to allocate for your debts each month.

It's a good idea to calculate your DTI for a few reasons. For one thing, knowing your debt ratio can help you build your monthly budget by showing you how much to allocate toward repayment of debts. Plus, keeping your DTI in perspective can help you determine whether or not you're comfortable taking on new debt.

Understanding the DTI ratio

There are two sides to every DTI: the front-end ratio and the back-end ratio.

The front-end ratio, sometimes called the housing ratio, calculates the percentage of your income needed for monthly housing-related expenses. This includes things like mortgage payments, homeowner's insurance, HOA fees, and property taxes.

The back-end ratio calculates the percentage of your income needed to pay all your monthly debts. This includes car payments, student loans, and credit card bills, plus all the housing expenses covered in the front-end ratio. In other words, a back-end DTI includes all debts in its calculation, while a front-end DTI is exclusive to housing debts.

Why your DTI ratio matters

It's a good idea to know your DTI simply for monthly budgeting purposes. But the importance of debt-to-income ratios goes beyond personal finances.

If you have plans to take out a loan in the future, your DTI could affect the amount you can borrow. Lenders will typically evaluate both your DTI and your credit history to determine your risk as a borrower.

A high DTI signals to lenders that you might have trouble making monthly payments. If your DTI is higher than their acceptable range, you could be approved for a significantly lower amount—or for nothing at all.

How to calculate debt-to-income ratio

Luckily, you don't have to leave your DTI to the lenders. Calculating your own debt-to-income ratio gives you the chance to evaluate it on your own terms—before you apply for a new line of credit. And once you've got your number, you can start building a strategy to lower it if necessary.

Even if you aren't mathematically inclined, finding your DTI is a relatively simple process. Follow these four steps to find your monthly debt ratio:

Step 1: Add up your monthly debt payments

The first step in finding your DTI is to combine your monthly debts into a single figure. Simply make a list of your debt payments for the month, and then add them all up to get the total. From credit cards to personal loans, don't leave any debt out.

At this point, you can choose to find your front-end ratio by adding up only housing-related debts. For the standard back-end DTI, add up all of your debts, including housing, as mentioned above.

It's important to note that not every expense is included in the back-end DTI ratio—only those that go toward paying back debt. Make sure to leave out things like groceries, healthcare expenses, and utilities, since lenders don't include these in their risk analysis.

Step 2: Determine your gross monthly income

Next, you'll need to determine your gross monthly income (GMI), which is the amount you earn every month before taxes or other deductions have been taken out. If you aren't sure what your monthly income is, simply take your yearly salary and divide it by 12 to get your GMI. If you receive court-ordered payments, make sure to add them to this number.

What if your income varies from month to month? In this case, you can estimate your earnings and use that number as your GMI. Or, list your monthly earnings for the past year and use that average instead.

Step 3: Divide payments by income

Now that you have your two numbers, it's time to do a little bit of math. Take the figure for your total monthly payments and divide it by your gross monthly income. This number is your debt-to-income ratio, but it still needs to be converted into the right form.

Step 4: Convert to a percentage

To get your DTI in the right format, simply multiply your number by 100 and add a percent sign. Then, you're done!

Calculating your DTI ratio: an example

Still not sure how to calculate your debt-to-income ratio? To clear up any confusion, here's an example to follow along with:

Let's assume you have two sources of debt to repay this month: a $300 auto loan and a $300 student loan. Following step one from above, we'll add these two together to get your total monthly debt payment: 300 + 300 = 600.

Now, we need to find your gross monthly income. If your yearly salary is $36,000 before any deductions, we can divide it by 12 to get your GMI: 36,000/12 = 3,000.

From here, we'll divide your monthly debt payments by your GMI: 600/3,000 = 0.2. This is the decimal form of your DTI, meaning it just hasn't been converted into its final form. To turn this number into a percentage, multiply it by 100: 0.2 * 100 = 20%.

So, 20% is your DTI for the month. In other words, 20% of your monthly earnings will go toward debt payments. But what does this really mean for your finances?

What is a good debt-to-income ratio?

Not all debt ratios are created equal. A single DTI may be manageable for some but too high for others. That being said, there are a few general guidelines you can use to determine if your DTI is within a comfortable range.

Below 36%

If you own a home, your back-end DTI will ideally be no higher than 36%. This is a manageable debt level for most homeowners and typically won't prevent you from opening new lines of credit.

If you're a renter, things are a little different. Since you'll dedicate a significant portion of your income to rent, which is a non-debt payment, it's a good idea to keep your DTI within the 15%-20% range.

36% to 42%

If your DTI falls within this range, lenders might not be eager to allow you to take out additional loans. At this point, you should start thinking about ways to repay your debts and lower your ratio. You may be able to get your DTI below 36% with a do-it-yourself strategy like the snowball method.

43% and above

Once your DTI surpasses 43%, you'll likely have trouble opening new lines of credit. To lower your debt, consolidation is an option to consider.

DTI ratio and your credit score

By now, you know that your DTI plays a big role when it comes to being approved for new loans. But can your debt-to-income ratio affect your credit score?

The answer is technically no, your DTI is not factored into your credit score calculations. However, your debt ratio may impact your credit indirectly.

Your credit utilization rate is the percentage of available credit in use at any given time. Since credit accounts are included in DTI calculations, a high debt ratio could also mean a high utilization rate.

A lower utilization rate is often a side effect of a lower DTI. When this happens, credit scores tend to go up — just one more reason to keep your DTI as low as possible.

Lowering your DTI ratio

Speaking of low debt ratios, you don't have to settle for a high DTI. With a little planning, you can reduce your debt ratio and have more money to treat yourself every month. Here are some ways to keep your DTI in a comfortable range.

Avoid additional debt

If your DTI is already higher than you'd like, the best thing you can do is avoid taking on additional debt. Since your DTI is a ratio of debt to income, adding debt will only increase your percentage, unless you happen to get an incredible raise in the meantime.

In most cases, avoiding new debt is easier than paying back existing debt. If you can, limit any new lines of credit until your DTI is more manageable.

Reduce existing debt

Eliminating existing debt is the easiest way to directly lower your DTI ratio. You can keep things simple by paying off debts in order from smallest to largest, or go the opposite direction and tackle the accounts with the highest interest rates first. Even tackling credit card debt alone can positively impact your DTI.

Consolidating your debt is an option that works particularly well for personal loans. Auto loans and mortgages can even be lowered by refinancing, especially if your credit score has improved since the start of your loan.

Don't make minimum payments

It's tempting to make minimum payments every month—after all, who wouldn't want more money in their pockets at the end of the day? But always paying the minimum means you're stuck with extra monthly interest charges. Plus, these payments will remain on your DTI month after month.

Reduce your debt faster by paying more than the minimum payment every month. You'll minimize interest charges and lower your utilization rate while you're at it.

Stick to a budget

Just like the rest of your finances, a debt-to-income ratio is better managed when you have a plan. Making and sticking to a budget every month can help you eliminate debt by reducing excess purchases, leaving more money to put toward paying off your debt.

Having a budget also means you're less likely to add to your credit at a moment's notice. Consider making a monthly budget to guide your spending. Add some DTI-lowering strategies to your plan, and watch your debt melt away month after month.

Debt-to-income ratio: the bottom line

A debt-to-income ratio is just as important to your personal finances as it is to a lender's risk analysis. Finding your ratio can not only help you budget and reduce debt but also estimate your own credit eligibility.

A DTI below 36% is ideal for most homeowners, but no ratio is set in stone. With the right planning and a little time, you can get your DTI down to a level that works for you.

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