Welcome to Day 7 of the 30-Day Financial Wellness Challenge.
Each day will comprise of financial exercises, some short and others a bit longer, to help you become financially fit. The goal is to tackle different aspects of personal finances one day at a time.
After the 30 days, you’ll have a stronger understanding of your financial health and an action plan to improve your financial wellbeing. Review Day 6: Liquidity and Cash Ratio
On Day 7, we’re calculating your debt-to-income ratio (DTI).
Do you know how much debt you hold? If you’re holding too much debt in relation to your income, it can be a sign of future financial troubles.
In my banking career, I became a certified loan officer. I learned the ins and outs of underwriting with the authority to approve loans up to a certain limit. It was during that time, I was introduced to the debt-to-income ratio easily referred to as DTI. When making loan decisions, I needed to know whether or not an applicant’s income was sufficient to cover their existing debt and ability to repay new debt.
The DTI is one of those important numbers lenders use. It also says a lot about your relationship to debt and can reveal the severity of future financial stress.
Today, I’m going to show you why the debt-to-income ratio is important, how to calculate it, and what an ideal DTI means to your financial health and wellbeing.
Debt-to-income Ratio Defined
A debt-to-income ratio (DTI) measures the amount of debt you have compared to your overall income. It’s used primarily by lenders to measure your ability to manage the payments you make each month and repay the money you have borrowed.
Why DTI is important
Your DTI can easily show the precariousness of your financial situation. For example, if your DTI shows 70% of your income is used for debt payments, it may indicate serious financial trouble and an inability to pay if income decreases or other monthly expenses grow.
For lenders, DTI is important because it measures risk. Lenders use the debt-to-income ratio to determine if you’re a risky borrower with a higher probability of defaulting on a loan when facing financial hardships.
How to calculate your Debt-to-Income Ratio
Your debt-to-income ratio is calculated by dividing your monthly debt payments by your monthly gross income. The DTI ratio is expressed as a percentage.
DTI Ratio = Monthly Debt Payments / Monthly Gross Income
To calculate your DTI with the following steps:
Step 1: Add up all your monthly debts payments and includes rent, child support, alimony payments but excludes utilities, groceries, and other discretionary expenses. (Day 3 Challenge)
Step 2: Divide the total debt payments with your gross income (Day 2 Challenge)
For example:
Step 1: Total monthly debt = $3,000
Step 2: Gross Income = $6,000
DTI Ratio = 0.50 = $3,000 / $6,000
You can convert the decimal value into a percentage.
DTI Percentage = 50% = (0.50 x 100)
This makes it simpler to say that 50% of your gross income is used to repay monthly debt obligations.
What calculating your debt-to-income ratio reveals?
Calculating your DTI may help you determine how comfortable you are with your current debt, and also decide whether applying for credit is the right choice for you. It helps you (and also a lender) determine whether or not you can afford to take on another monthly payment.
Day 7 Assignment
Let’s calculate your DTI Ratio
- List your debts. (Take from the Day 3 Challenge)
- List your gross income. (Take from the Day 2 Challenge)
Calculating Your Debt-to-Income Ratio
| Example | ||
| Total Monthly Debt | $ | $3,000 |
| ÷ Gross Income | $ | $6,000 |
| = DTI Ratio | 0.50 | |
| What does it mean? | 50% of your gross monthly income is allocated towards monthly debt payments. | |
Why is the DTI ratio important to you?
- Help you determine if a loan is truly in your best interest. You get to decide for yourself, not a lender.
- Before applying for a mortgage, having your DTI within a lender’s guidelines can increase likelihood of approval.
- Knowing your DTI helps you focus attention on activities to lower debt and improve your financial health.
Additional Reading:
- Creative Ways to Supplement Your Income
- Consolidating Multiple Credit Card Payments
- Ways to Lower Your Debt-to-Income Ratio
Resources:
- Personal Capital is a free personal finance app with a 360-degree view of your money. With Personal Capital, you can see all your accounts in one place with planning and analysis tools.
- Cleo and Charlie are the perfect personal financial assistant you can text and chat. They give you insights on how you’re spending, how much you’re saving, and other useful financial tips.
- Find a credit card consolidation loan. Visit the financial marketplace for consolidation loan options.
Next Daily Challenge: Day 8 – Credit Score: What’s your credit health?
Frequently Asked Questions
What can I do to lower my DTI?
The good news about DTI is that it’s not fixed. It changes as you pay off debt, lower minimum monthly payments, reduce rent or by increasing your income. Learn more ways to lower your debt-to-income ratio.
What is an ideal debt-to-income ratio?
Personally, the lower your DTI the better because this means much of your income is not allocated to debt payments. This allows more flexibility in using income to create wealth.
When applying for a loan, it depends on the underwriting guideline of the lender. Most lenders prefer DTI ratios below 40%. With mortgages, lenders may want ratios below 30%. Personal loans, however, tend to have higher acceptable DTI ratios.
Can I be denied a loan even with an excellent credit score?
Yes. Lenders use many different financial indicators in making a decision. They often look at your credit score, but will also calculate your DTI based on the information pulled from your credit report and the income you shared.
