From credit card payments to your mortgage, everything you pay for is factored into your debt ratio.
If you’re thinking about applying for new credit, many lenders will take a closer look at your debt-to-income ratio to ensure that it’s in line and where it needs to be. It won’t be wrong to say that a high debt-to-income ratio is one of the most common reasons for loan denial or getting a loan at a higher-interest rate.
Read on to learn more about this crucial ratio, what it is, and what you can do to get yours at a reasonable percentage for better approval odds.
What is A Debt Ratio?
A debt-to-income ratio (DTI) takes a look at your current monthly debt expenses and compares them to your monthly gross income. This figure is easy to determine by simply adding up all of your monthly debt payments. The term debt, in this case, includes things like credit cards, car loans, and housing expenses like rent or mortgage.
Once you’ve added up all your monthly debt-related expenses (do not include food or utilities), divide that number by your monthly gross income. This is the amount of money you get paid before taxes and other deductions are taken out of your paycheck.
As an example, let’s say you pay $2,000 per month on credit cards, car loans, and rent. If you make $5,000 per month in gross income, you will need to divide $2,000 by $5,000. That means your DTI or debt ratio, or debt-to-income ratio is at 40 percent.
Why is this Number Important?
Many lenders, particularly mortgage lenders, want to know how much debt a new customer can take on to ensure they’re reliable with making payments. If you currently have a lot of outstanding debt in comparison to your income, you might not be a good candidate for a new loan.
Each lender or bank has different guidelines when it comes to the right debt-to-income ratio. These numbers can vary widely, but in most cases, 36 percent or lower is considered a “safe borrower.”
In order to be approved for a home loan, car, or another major type of credit, your DTi should be as low as possible. Fortunately, there are some things you can do to improve your debt ratio to get approved.
How to Improve Your DTI
One very effective way to improve your current debt ratio is to increase the amount of money you pay toward debt. These extra payments will help you pay off your debts faster, which can reduce the amount of outstanding credit utilization you have.
Avoid taking on more debt by staying away from credit card applications and new loans. Try not to make major purchases using a credit card, or else you’re merely increasing your current debt, making your debt ratio worse.
Keep track of your debt-to-income ratio and look at ways to improve it every month. As you see the number get lower, you’ll be encouraged to keep going until your debts are low in comparison to your income.
Keep Your Credit Healthy
Your debt ratio is just one part of a healthy credit profile. Make sure you don’t have too much debt and try to reduce your ratio for easier approval when you’re ready to make a major purchase like a home or vehicle.
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