What Is Debt To Income Ratio? [And Why It Matters]

debt to income ratio

The sad fact is the average American is severely in debt. Our debt culture embraces debt and believes it is a necessary tool to live our lives. Our debt to income ratio is rarely scrutinized unless we apply for a mortgage. We go into debt when we get our first car, we use credit cards when we want to buy the things we don’t have the money for, and we believe we will be paying for our homes for the rest of our lives.

We basically use debt to lead our everyday lives.

Looking At Debt To Income Differently

But what if I told you there was a different way to live – and still enjoy life? While still in our 30’s, my wife and I recently paid off our home and refuse to make other people rich at our expense.

If you were to ask the average person how much debt they have, most are unable to tell you because it’s not something we like to acknowledge. Most people roughly know how much is left on their home and their car, but they pay more attention to how much their monthly payments are. The idea of paying things off doesn’t usually seem like a realistic goal.

Unfortunately, debt is not something that should be ignored. Not only does the amount and type of debt you have impact your credit score, but severe debt can also be a burden in your life.

Traditionally, parents and the education system fail to properly equip children with the financial knowledge needed to be financially successful later in life. Most people are not financially savvy because financial fitness is not something that is taught in school, so it comes down to each individual to teach themselves about how to change their financial future.

What Is Debt?

In the most simple terms, debt is anything that you owe. This could be a credit card payment, student loan payments, a mortgage payment, or a debt consolidation loan. You are indebted to the lender of your loan until you get the debt paid off.

Owing people money isn’t in itself bad, but the problem is attached to the amount of money you will pay in interest over the course of the loan. The amount of money you repay in the form of interest can be astronomical depending on how the loan is structured.

Breaking down the total interest we would owe on our home was one of the reasons my wife and I paid off our mortgage as soon as possible. Over the life of our mortgage, we were on course to pay the bank tens of thousands of dollars extra, just for borrowing the money in the first place.

Student loan debt is some of the most common debt in America. Apart from student loans, most people have car loans, and they also pay a mortgage for their home. Regardless of the type of debt that you have, if you are making monthly debt payments, you are not free.

Until you finish making your debt payments, you are owned, in a sense, by the entity that gave you the loan. Unfortunately, some people believe student loan debt and a mortgage will be with them for life so they do little to change this perception. In reality, you can get out from under this weight faster than you may realize.

What Is A Debt To Income Ratio?

If you are interested in purchasing a home, a car, or if you are looking to take out a loan for any other reason, your lender will scrutinize your debt to income ratio. To put it simply, your debt to income ratio is a calculation of your gross monthly income to the amount of recurring monthly debt that you have.

How To Calculate Your Debt To Income Ratio

Each person should be able to calculate their own debt to income ratio. To do this yourself, follow the following formula:

Here is a real world example of the formula in action:

Step 1: Calculate all monthly debt payments

Let’s say all of our monthly debt payments include our vehicle payment is $400 a month, $300 a month for minimum credit card payments, and $1,600 a month for our mortgage.

If this is all the monthly debt payments we make, we total these up and find that our total monthly debt is $2,300. ($400 + $300 + $1,600 = $2,300)

Step 2: Calculate your gross monthly income

Next, we identify our gross monthly income and put it into the equation. Our gross monthly income is how much money you earn each month before taxes are taken out.

For this scenario, let’s assume our monthly gross income is $5,000.

Step 3: Divide your totals

Divide your total monthly debt payments by your monthly gross income. In this scenario we would do the following: $2,300 (divided by) $5,000. This calculation equals = 0.46.

Step 4: Find your debt to income ratio percentage

For the final step, multiply your final calculation by 100. Here we would take 0.46 times 100. The end result is 46.0. In this scenario, our debt to income percentage is 46%.

What Does This Mean?

The higher your debt to income ratio is, the worse off you look to creditors. Having a high debt to income ratio could mean that you are living beyond your means. If your credit utilization ratio is high, you are quite possibly using credit to make the majority of your purchases, and without the credit, you would not be able to make ends meet.

A high debt to income ratio is a red flag for any lending company. If they see you have too many debts, the company is most likely not going to give you more credit. And if they do, they’re going to charge you a higher than normal interest rate.

To avoid overpaying with high interest rates, I’ll show you how to improve your Debt To Income (DTI) score.

What Is A Good Percentage Of Debt To Income Ratio?

Since your debt to income ratio can keep you from getting a loan with a reasonable interest rate, we need to examine how bad (or good!) your situation is before you apply for a loan. According to Investopedia, mortgage lenders use DTI in their calculations and believe the ideal debt to income ratio is 36% or lower and your mortgage loan should be no more than 28% of your total DTI. Some lenders like to see an even smaller amount.

If your DTI ratio is lower than that, you’re in a good position! If, like many Americans, your income ratio could be better, there are several ways to improve your situation with a debt management plan.

What Happens If My Debt To Income Ratio Is Too High?

If your debt to income ratio is too high, it is possible that you will not be able to get a car loan or mortgage. Lenders want to be able to see you can handle and responsibly repay your loans on time.

If you have a higher than normal DTI, lenders are less likely to trust your ability to pay them back. The result is a high-interest rate loan or an overall denial of your application.

What Is The Average Debt To Income Ratio In America?

Unfortunately, there is no solid data that shows the ability to uncover the average DTI ratio in America. We do know, however, that the median income in America is $61,372 while the average debt is $137,063.

By looking at the different income and debt statistics, we can estimate that the average DTI in American is between 37%-43%. If you have a good debt to income ratio, you are probably making savvy financial decisions and have trained yourself to be financially responsible. You are a person who pays off your debt on time, and you make paying down debt a priority.

If you have a high debt to income ratio, it does not mean that you are a terrible person. We all have financial circumstances that come up that we were not prepared for. You may also have a low total monthly income, and because of sickness or income loss, you may not be able to keep up with your monthly debt obligations. You may feel like there is no way to get out of credit card debt, and you may regret some of your past decisions. If you relate to the situations previously mentioned, know that it is in your power to improve your situation.

However, on the flip side, if you’re focused on living in the moment and are comfortable spending money you don’t have – I hate to say it, but you are the problem.

How Can I Lower My Debt To Income Ratio Quickly?

It will take effort, intentional spending, and saving to lower your debt to income ratio quickly. First and foremost, you need a monthly budget. You have to know how much money you are earning and how it compares to your spending.

Instead of your money leading the way, you have to give your money assigned tasks each month; this is what a budget does. You are going to need to start making large payments on your loans and your credit cards to lower their balances. Making the minimum monthly payments will leave you going nowhere fast.

If you find that you are not making enough to pay more than the minimum payments each month, you may need to increase your income or find ways to drastically reduce your spending. If you feel like it is impossible to improve your income, then it may be wise for you to look into debt consolidation options.

If your income to debt ratio is high, your debt is controlling your life, and you are the only one who can stop the cycle. Be sure to check your credit report for any other debts you may have forgotten about.

If you need guidance, check out my Debt Payoff Playbook.

Should I Pay Off My Credit Card Debt Before Applying For A Mortgage?

Before you get a mortgage, get out of debt. That means paying off your credit card companies, your car, and your student loans. A house is the largest purchase that you are going to make and by eliminating these other loans, you can all but guarantee you will be able to afford your mortgage mortgage payment for years to come.

The less debt you have and the more money that you make, the more likely you will get a low-interest rate on your mortgage which will save you tens out thousands of dollars.

Take Control Of Your Debt

Most people are convinced they will be in some form of financial debt for their entire life. However, I encourage you to think differently! My wife and I were able to pay off both of our vehicles, all our credit cards, and our mortgage on a single income – with a family of five! I’m telling you this so you realize living debt-free is possible and in your future – if you choose it.

By making savvy financial decisions, and by spending below your means, you can pay off your debt completely. It may sound impossible, and you won’t be keeping up with the Joneses, but you will have what you need to live an abundant life.

Money management skills can start at a young age.

  • Instead of buying the car of your dreams, save up while you are still living with your parents, and get a vehicle you can afford.
  • Instead of going to a prestigious college, go to a local college or trade school to avoid hefty student loans.
  • Instead of buying that house in a wealthy neighborhood, buy an affordable home you can pay off in 15 years or less.

Some people believe that making more money is the key to improving debt issues, but rich people have just as many debt issues as the poor. The key is balance and education. Once you take control of your finances, your debt will no longer be your boss. Eliminate your debt, and you will significantly improve your life.

General FAQ

What Is Debt?

Debt is anything you owe to someone else. In financial terms, debt is commonly associated with loans such as mortgage loans, outstanding credit card balances, auto loans, student loans, etc.

What Is A Debt To Income Ratio?

Your debt to income ratio is a calculation of your gross monthly income to the amount of recurring monthly debt that you have.

How To Calculate Your Debt To Income Ratio

The Debt To Income Formula Is: (Total of your monthly debt payments) / (Gross monthly income) = (Answer) x 100 = Debt to Income ratio percentage.