What Is a Debt-To-Income Ratio?
Your debt-to-income ratio (DTI ratio) shows your monthly debt obligations – including all installment and revolving debts – as a percentage of your income.
How Do I Calculate My Debt-To-Income Ratio?
The calculation for DTI ratio is an easy one. First, add up all of your recurring monthly debt payments. (Remember to count all installment payments that appear on your credit report including student loans, car payments, and child support payments.) Then simply divide by your monthly income before taxes.
So, for example, if you have a $400 car payment and a $250 student loan obligation each month and your monthly income is $5000, your calculation would look identical to the one below:
($400 + $250)/$5000 = .13
In this case, your DTI ratio is 13%.
When Your Debt-To-Income Ratio Matters
Typically, your DTI ratio is most important when you’re looking to purchase a home. Put simply, lenders want to know that you’ll have enough money left over every month after paying existing debts to pay them back as well. While there’s no universal criteria for what constitutes a healthy DTI ratio, the 36/28 rule is one that’s widely referenced. This rule says that your debt expenditures should total less than 36% of your monthly income, with no more than 28% of your income devoted to housing.
Your DTI ratio doesn’t have a direct impact on your credit score.
How to Improve Your Debt-To-Income Ratio
To improve your debt to income ratio, you have two options: (1.) reduce your monthly payment obligations by paying down debt or (2.) increase your income.
To some people, these options might sound limiting. So, it’s important to note that while the 36/28 rule usually applies to those seeking Qualified Mortgages, there are other types of mortgages more forgiving of high debt-to-income ratios.
What Is a Credit Utilization Rate?
Your credit utilization rate is the percentage of your total available credit that you’re currently using.
How Do I Calculate My Credit Utilization Rate?
This is another straightforward calculation. Add up all of your credit card balances. Then divide by the sum of your credit limits.
So, for example, if you have a balance of $100 on Card A and a balance of $600 on Card B, with a credit limit of $1000 on each card, your calculation will look like the one below.
($100 + $600) / ($1000 + $1000) = .35
In this case, your credit card utilization rate is 35%.
When Does Credit Utilization Matter?
Unlike DTI ratio, your credit utilization rate does have a direct impact on your credit score. In fact, amounts owed account for up to 30% of your credit score.
As a rule of thumb, your credit utilization shouldn’t exceed 30% of your available limit. It’s also a good idea to keep individual card balances below that same 30% threshold.
How to Improve Your Credit Utilization Rate
If you’re able to pay down your balance, it’s always a good idea to do so.
In some cases, you may be able to open an additional card account, which will help to reduce your overall credit utilization. However, it’s important to note that this might not have the impact you’d like when utilization of an individual card far exceeds the 30% mark.