How Your Debt-to-Income Ratio Affects Your Credit Score
A debt to income ratio (DTI) is a basic calculation that lenders use to determine whether or not a borrower is capable of meeting their monthly debt payments. It’s a great way to evaluate someone’s financial health and can benefit the borrower as much as the lender.
We have already covered this topic extensively in our Debt-to-Income Ratio Calculator page, but in this guide, we’ll see how this calculation directly affects your credit score and how it is used by mortgage lenders, loan companies, and credit card providers.
What Data do You Need to Calculate Your Debt to Income Ratio?
Your debt-to-income ratio compares your monthly income to your monthly debt and is used to determine whether or not you can afford current and future payments. Along with your credit utilization score, it’s a great indicator of financial health.
To calculate this score, simply add-up your gross income and then compare this to your monthly debt payments. The percentage you arrive at is your debt to income ratio.
If, for example, your monthly debt payments include $500 on credit card debt; $250 on loans; $1,000 on a mortgage, and $250 on other recurring monthly debt, then your total monthly debt is $2,000. If your monthly income spans $5,000 on wages and $1,000 on investments, then your gross income is $6,000.
Once you have those figures, then simply divide your monthly debt by your total monthly income and represent this as a percentage. In this case, that gives us 33%, as $2,000 (monthly debt) is 33% of $6,000 (monthly income).
How Your Debt-to-Income Ratio Affects Your Credit Score
While there are some similarities between your debt-to-income ratio and credit utilization score, there is one major difference: Your debt-to-income ratio won’t directly affect your credit score while your credit utilization score will.
It’s more of an affordability thing. Your DTI’s purpose is to tell mortgage lenders whether you can meet monthly payments or whether your other debt obligations will get in the way. Because, as discussed in our guide, Minimum Credit Score for Buying a House, foreclosure is incredibly costly for the bank and they will do everything they can to avoid it.
Your debt-to-income ratio will also be considered by credit card companies and other lenders, but its main purpose is to determine whether your monthly debt payments will get in the way of your mortgage payments.
Why is it Important?
If your DTI doesn’t impact your credit score like credit utilization, what purpose does it serve?
Well, for one thing, it tells lenders how likely certain financial obligations are to get in the way of your monthly debt payment or mortgage payment. This is something that your credit utilization doesn’t consider as it looks only at your total debt and available credit and doesn’t factor your monthly income into the equation.
Your DTI, therefore, helps lenders to see the whole picture. It can also be used by the borrower to assess their financial situation.
Strategies for Improving Your Debt-to-Income Ratio
If your DTI creeps above 43% you will be refused a Qualified Mortgage and may struggle to get any sizeable loan with a low-interest rate. This is true even if you have a respectable credit score. However, fixing your DTI will greatly improve your financial situation and make it considerably easier to acquire a mortgage and loan in the future.
Here are a few ways you can improve this ratio:
Understand Your Debt
Your first step to improving your debt-to-income ratio is to better understand your financial situation. Calculate your score and then analyze all your debts, income, and additional expenditures, understanding how big your monthly payments are and how deep in the red you are.
You may be surprised to learn that you’re spending a lot of money on frivolous items, that you’re paying excessive amounts of interest or penalties, and that you’re not earning as much as you thought you were. All this information can help you to comprehend your financial situation and prepare you for a mortgage.
Target the Highest Bill-to-Balance Debts
Compare all monthly debt payments against the size of their respective balances and write down a percentage for each. If, for example, Debt 1 costs you $100 a month on a $1,000 balance while Debt 2 costs $50 on the same balance, then Debt 1 is 10% and Debt 2 is 5%.
Your next step is to focus all your expendable income on the debt with the highest percentage. Once you get that out of the way then your situation should improve significantly.
Make More Money
It’s always easier said than done but earning more money will improve your income ratio considerably. You can negotiate a pay increase with your employer or take on additional part-time freelance work. Your debt-to-income ratio will drop for every additional dollar that you earn, so if they refuse a significant increase then push for a smaller one.
We’re living in a gig economy and it has never been easier for skilled workers with a little time and talent to make some money on the side. You can write, draw or perform administration work, earning anywhere from $10 to $100 an hour depending on your level of skill and experience. Don’t worry if you don’t have much of either to speak off—there are multiple jobs available for anyone willing to put the hours in.
Renegotiate your Debt
Lenders are always happy to renegotiate debts. You can improve credit limits, reduce interest rates, decrease monthly debt payments, and more. It doesn’t hurt to ask and if they believe that it’ll reduce the odds of a default, they’ll be happy to accept.
Your main goal is to lower monthly payments but remember that this could be done at the expense of a longer long-term and an increased balance. Don’t get tempted by the first offer they wave in front of you and always run the necessary calculations before accepting.
Use a Balance Transfer Credit Card
A balance transfer credit card allows you to move all credit card debt onto a card with a 0% introductory interest rate. You may get an increased credit limit and some additional perks as well, but you need to focus on clearing your debts during this introductory period as the APR may be higher than usual when it ends.
If you pay less interest, your monthly outgoings drop significantly and your DTI will improve as a result.
Re-Think Your Investments
Your monthly income includes all money you earn from investments so it’s good to have these. However, you may be better off cashing those investments in and using the money to clear some of your debts. Unless you have your money invested in a burgeoning tech firm generating massive turnover, your debts will always cost you more than your investments will save.
As an example, let’s imagine that you’re getting a guaranteed return of 5% a year on investments of $5,000. That’s $250 a year and after 5 years it will hit just under $6,400 with compound interest for a total gain of $1,400. If you run the same calculation on a credit card debt of $5,000 with a low APR of 16% and a payoff period of 5 years, it’ll cost you over $2,200 in interest before fees and penalties.
The monthly income from this investment will also be significantly lower than the monthly interest payment, so not only will you save $800 during the lifetime of the debt, but you’ll reduce your DTI as well.
By the same token, you should also reconsider your savings.
Cash Your Savings
Unless you’re getting a very high rate, there’s a good chance that your debt is costing you more than your savings are earning. If these savings are tucked away for a child’s education, then keep them there, but if the goal is to pay for a holiday or another major and unnecessary expense, consider cashing them in and using the money to clear your debts.
If you’re not convinced, run some calculations, looking at how much those savings are earning you compared to how much your debts are costing you. The picture this paints should be pretty clear.
Summary: The Importance of Your DTI
As discussed already, your debt-to-income ratio not only helps mortgage lenders determine your level of risk, it can also help you understand your financial situation. It’s a number that all borrowers should learn, alongside their credit score and their credit utilization score, and one that can play an integral role in helping you to rebuild your finances and prepare for a mortgage, a consolidation loan, or even just a simpler and less stressful future.