Learn how to minimize negative changes to your credit score when consolidating debt.
What is debt-to-income ratio?
Debt-to-income ratio refers to how much of a borrower’s monthly income is eaten up by debt. Creditors, especially mortgage lenders, want to know what’s left over after all monthly bills are paid.
The ratio is calculated by dividing monthly debt payments by gross monthly income. It’s a key barometer for lending someone money.
Also known by lenders as the back-end ratio, the debt-to-income ratio impacts a person’s credit score and the types of lenders willing to lend a borrower money.
There is nothing magical about how debt-to-income is determined. Use Bankrate’s debt-to-income ratio calculator or take pencil to paper to figure it out.
Step 1: Add up all monthly bills, including minimum credit card payments, car payments, alimony or child support, rent or mortgage payments, and student loans.
Step 2: Divide the total debt by the gross monthly income (income before taxes).
Step 3: Translate the amount into a percentage. For example, if total debt is $2,500 and the gross monthly income is $6,000, divide $2,500 by $6,000 and end up with a debt-to-income ratio of 0.4166, or almost 42 percent.
To be sure, the lower the borrower’s debt-to-income ratio is, the better are the chances of getting a loan.
That’s because the higher a borrower’s debt-to-income ratio, the more likely he or she would have trouble making monthly payments. Most lenders would be less likely to make loans to people with a ratio of more than 36 percent, although they could be persuaded if the person’s credit is good. Here’s how Wells Fargo breaks down how lenders are likely to view your debt-to-income ratio:
- 35 percent or less: You look good. Your debt is at a manageable level.
- 36-49 percent: There’s room for improvement. You should consider lowering your debt-to-income ratio in case of an unexpected expense, like a medical bill or expensive home or car repair.
- 50 percent or more: You’re in the danger zone and are likely to have very little money left for emergencies. This debt-to-income ratio will severely limit your borrowing options.
A high debt-to-income ratio is not irreparable. Borrowers can lower their ratios by selling cars they’ve financed and by paying off credit cards. In addition, borrowers can consolidate other debts with cash-out mortgage refinancing if their homes have enough equity.
Debt-to-income ratio example
Jackie’s monthly income is $10,000, which is equivalent to $120,000 per year. Her monthly debt payments total $4,000. Her debt-to-income ratio is 40 percent. This ratio is above the maximum 36 percent that most lenders accept.
To qualify for a new loan, Jackie can lower her ratio by selling the vehicle she’s financed and by cutting her credit card debt. Or, if her home has enough equity, she can consolidate other debts with a cash-out refi.
Lastly, she can check with other lenders who might allow a higher debt-to-income ratio for loan approval.