Let’s clear up one major misconception: debt-to-income ratio is not the same thing as credit utilization.
The Difference between Credit Utilization and Debt-to-Income Ratio
Similar to credit utilization, the debt-to-income ratio is a measurement that lenders use to determine creditworthiness. However, the two formulas tell vastly different stories when it comes to lending potential; credit utilization determines how much of your existing credit is being used, whereas debt-to-income ratio measures how much you can afford to borrow. So, although there are a few overlaps between the two, credit utilization and debt-to-income ratio are not the same thing. The primary difference between the two is that credit utilization only takes credit lines into account – not loans. Card issuers can see how much available credit you’re using – the higher the number meaning the higher the risk. While useful, this percentage only tells one side of the story.
What Is Debt-to-Income Ratio Used For?
While it is important to have an idea of a person’s financial history and payment records, the DTI ratio determines how much of an individual’s income is currently going towards existing debt repayment. It is most commonly used by mortgage lenders and can give them a better idea of how much you can afford to borrow. Lenders want to make sure that your earnings aren’t already tied up in paying off other debts. If your income is already bogged down by car payments, student loans, or other things – the likelihood that you may miss a payment or default entirely is much higher than an individual who was fewer loans, and therefore more disposable income. Unlike credit utilization, the debt-to-income ratio does not affect your credit score in any way.
How To Calculate Debt-to-Income Ratio
Your debt-to-income is a simple formula that shows how much you owe from your monthly expenses compared to how much you earn per month (before taxes). The result will be a percentage that shows how much of your monthly income is currently going towards existing debt – and thus, whether you are able to afford a new loan.
DTI = (Total Monthly Debt Payments / Gross Monthly Income) x 100
- First, you must identify your monthly expenses and the minimum payment required. Add all the amounts from each bill to generate your “Total Monthly Debt”.
Common types of monthly bills include:
- Rent of Mortgage
- Car Loan
- Student Loans
- Alimony/Child Support
- Credit Card Payments
- Next, divide the sum of your monthly debts by the amount of your monthly income before taxes are taken.
- The dividend will be a decimal, simply multiply that by 100 in order to identify your debt-to-income percentage.
Example: You earn $5,000 a month but owe $1,000 in rent, $500 in student loans, $200 for car payments. Total Monthly Debt = $1000 + $500 +$200 = $1,700 Monthly Income = $5000 $1,700 / $5000 = .34 Debt-to-Income Ratio = 34%
What is a Good DTI Ratio?
The resulting number from the DTI equation tells what percent of your income is being used towards paying off existing debt. While the exact number of what qualifies as a good debt ratio will vary between lenders, the lower the debt-to-income ratio the better.
- DTI of 35% or less is typically considered to be a good debt-to-income ratio,
- DTI between 35-49% could use improvement but may still qualify for a loan
- DTI of 50% or higher will be considered too risky for most lenders – you will likely miss payments if an unexpected emergency arises
The debt-to-income ratio is only one of several equations the lenders will look at during the loan application process. While it’s not something you’ll have to worry about affecting your credit score or your likelihood of being approved for a new credit card, it’s important to understand how opening new lines of credit could affect your DTI ratio. If you are planning to apply for a mortgage in the near future, focus on improving this metric rather than your credit score. While paying off loans in their entirety could have ramifications on your credit score, it might be worth doing if your DTI is high (above 50%).
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