If you’re having a hard time qualifying for a loan, your debt-to-income ratio (DTI) might be a reason.
A debt-to-income ratio, often expressed as a percentage, measures how much you spend repaying debts using your monthly income. Most mortgage companies consider this ratio to determine the amount of monthly mortgage you will qualify for when applying for a loan.
What’s the Best DTI Ratio?
Calculating your DTI ratio is simple. Add your debt payments, then divide that number by your income and multiply the result by 100 to get a percentage.
Mortgage companies usually refer to the maximum DTI ratio set by the Consumer Financial Protection Bureau. According to the CFPB, 43% is the highest ratio a borrower can have to qualify for a loan.
There are exceptions to this rule. For example, your high DTI ratio is caused by aggressively paying off a loan so you can eventually use your money for savings and investments. Other times, lenders will agree to loan you money in good faith, but they have to determine if you can repay the loan.
How A High DTI Ratio Affects Your Finances
A high DTI ratio lowers your chances of qualifying for a loan, especially for auto and mortgage loans. Lenders want to make sure you can afford to make monthly payments, and they take a high DTI as a sign that you might miss payments or default their loan.
Having a high DTI ratio doesn’t affect your credit score, but some factors that lead to a high DTI could. High credit card and loan balances, plus default and missed payments, could lower your credit score.
Reducing Your DTI Ratio
1. Pay off your debts ahead of schedule
You don’t have to stick to your repayment plan. If you have room in your budget, pay more than the minimum monthly amount so you can settle your debt ahead of schedule.
Financers list a variety of methods to pay off your debt faster. You can use the debt avalanche strategy by paying off the highest-interest debt first or the snowball method that focuses on paying off your smallest debt first. These methods will increase your DTI temporarily, but it will eventually fall once you’ve paid off the majority of the amount.
2. Increase your income
Increasing your income means working overtime, asking for a salary increase, taking on a side hustle, or moving to a position with a higher salary. Use your earnings from this extra income to pay off your outstanding debts.
3. Refinance your debt
Restructure student loans or other large loans by extending their length. Doing so will reduce your minimum monthly payments, which will also reduce your DTI ratio. Refinancing is an excellent option if you qualify for a lower interest rate.
4. Use a balance transfer
Take advantage of any credit card promotions offering zero interest. Doing so helps you pay off your debt faster because you don’t have to calculate how much interest you have to pay each month. Make sure to settle your debt before the promo period ends and watch out for balance transfer fees.
A high debt-to-income ratio can affect your application for a loan. Reducing your DTI to the acceptable rate improves your overall budget and credit score, as well as puts you in the right financial position to buy a home or a car you can comfortably afford.