Almost everyone carries debt—whether it’s a mortgage, car payments, student loans, or a credit card balance. And while debt can be detrimental, in certain circumstances it can have a positive impact on your bottom line. For instance, a home that appreciates in value or a college degree that boosts your earning power.
No matter what kind of debt you have, there is a tipping point where the amount you owe is more than you can manage. Wondering how much is too much? That’s where the debt-to-income ratio (DTI) comes in.
Your DTI is a number, expressed as a percentage, comparing your total monthly debt to your gross monthly income. It’s considered a barometer of your financial health that lenders take into consideration when you apply for a loan, including a mortgage.
You probably already have a general sense of whether or not your DTI is too high. Are you scrambling to cover your monthly bills? Do you ever pay late because you don’t have enough cash on hand? Do you feel chronically stressed about finances? Those are all tip-offs that your DTI is out whack.
But it’s still important to nail down your exact figure. To do so, add up your monthly debt: car payments, rent or mortgage, student loans, any other personal loans, and minimum required credit card payments (don’t factor in credit card balances that you pay off in full because it’s not considered long-term debt).
Next, tally your gross monthly take-home pay, which is your salary including taxes and deductions, as well as any side income streams—for example, if you Airbnb your home.
Finally, divide your total monthly debt payments by your monthly income to find out your DTI.
For example, let’s say you pay $1000 for your mortgage, $500 for your car, and $150 for student loans. Your total monthly debt equals $1650. If your gross monthly income is $5000, then you’d divide $1650 by $5000 for a DTI of 33 percent. (Or use an online DTI calculator like this one, which lets you itemize your monthly debt.)
It’s always a plus to have more income and less debt, so generally speaking, the lower your DTI, the better.
More specifically, follow the 28/36 rule to make sure your DTI is on track. This rule of thumb states that a household should spend no more than 28 percent of gross monthly income on housing (also called “front-end DTI”), and that total DTI (or “back-end DTI”) should be a max of 36 percent. If your DTI is between 36-43 percent, you’re on shaky ground. Upwards of 43 percent? You need a money tune-up.
Your DTI can impact your financial opportunities. Most lenders adhere to the 28/36 rule when assessing loan requests and determining interest rates. Although DTI is not a factor in calculating your credit score, it does reflect your creditworthiness: The higher your DTI, the more likely you are to default. According to the Consumer Financial Protection Bureau, a DTI of 43 percent is the highest ratio you can have to receive a qualified mortgage.
A heavy debt load also takes a toll on your emotional and physical well-being. Research out of Northwestern University found that high debt relative to available assets is associated with greater rates of stress and depression, worse general health, and elevated blood pressure. It’s hard to relax and enjoy life if you’re worried about whether or not you’ll be able to pay your bills. Plus, having such a thin cushion makes it difficult to bounce back from financial curveballs, like an unexpected car expense or job loss.
To lower your ratio, you can reduce your debt, increase your income, or a combination of the two.
First, look at the list you compiled of your monthly debt, and consider how you might take a chunk out of those payments—say, by getting a roommate or moving to a cheaper area of town; trading in your nice car for a more basic ride or public transportation; consolidating your student loans or being more aggressive about paying off outstanding credit card debt.
You can also brainstorm strategies to boost your income. Can you ask for a raise, find a better-paying job, or take on extra consulting work? A low-key side hustle can also pad your wallet—and lower your DTI—without adding stress. Offer computer assistance if you’re tech-savvy, walk dogs, tutor, or give lessons if there’s something you have a talent for—from speaking French to playing the guitar.
Put some of these changes into action and it shouldn’t take long for your wallet—and your well-being—to reach a happier place.
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