If you’re shopping around for a new loan, whether for a home, car, or otherwise, you may be wondering if your existing debt will keep you from qualifying. It’s true that lenders may assess your current debt-to-income (DTI) ratio to be sure additional debt won’t overburden you financially (and eventually cause a default down the road).
But it’s easy to find a reasonable amount of debt that you can take on based on your existing debt and income, especially if you use a tool like a debt snowball calculator.
What is DTI ratio and how do you calculate it?
One way to assess how much debt you can take on is by calculating your debt-to-income, or DTI, ratio. This simple calculation divides your existing debt by the amount of income you bring in every month and can be broken down into three easy steps.
1. List and add up all minimum monthly payments on existing debt.
The focus here is debt payments, so leave out other monthly expenses like utilities, transportation costs, or contributions to retirement or savings accounts. But be sure to include payments like your rent or mortgage, auto loan, credit cards, and student loans. Keep in mind that if you plan to apply for new debt with a spouse or partner, you’ll want to include their debt and income in this calculation as well.
2. Determine your gross monthly income.
If you work one full-time job, this number will be the amount of pre-tax income you earn each month. For example, if you earn $50,000 per year, your monthly pre-tax income would be $50,000/12 = $4,166.67. If you have multiple jobs or side hustles, add together all sources of taxable income.
Divide the result from step 1 by the result from step 2, shown in the formula below.
Your result will be a decimal value which you’ll convert to a percentage.
(Sum of all monthly debt payments) / (Sum of all sources of monthly income) = DTI ratio
Let’s look at an example. Say you have the below debt and earn an income of $60,000 per year.
Student loans: $450
Car loan: $200
Credit card minimum payment: $150
Debt total = $1,600
Monthly income total = $60,000/12 = $5,000
$1,600/$5,000 = .32 = 32%
But how do you know if your DTI is considered good or bad?
What is a good DTI ratio?
When it comes to assessing debt in any manner, a good rule of thumb is that less is better. But if you’re looking for a number to beat, the general recommendation is to maintain less than a 35% DTI ratio. But keep in mind that number may change based on the type of debt you’re looking to take on.
For example, if you’re buying your first home and looking to use a conventional loan, the maximum DTI to qualify is 45% or less. But you could receive an exception for a slightly higher DTI ratio if you have other financial factors like large cash reserves.
Before you apply for a loan, it’s wise to connect with potential lenders to confirm their expectations for DTI. Then, if yours is too high, you can work to pay down debt or increase income to shift your DTI in the right direction.
The bottom line.
When you consider taking on new debt, lenders want to know if you’re financially responsible and can make the payments. And DTI ratio is one way for lenders to gain visibility into your financial position. So calculate your DTI and talk to lenders before applying for loans to see if your current situation qualifies you to take on more debt. Then, if it’s too high, use strategies like paying down debt and increasing income to move your DTI ratio into an acceptable range.