In this article:
- What Is a Debt-to-Income Ratio (DTI)?
- Why Is DTI Important?
- How Is DTI Calculated?
- How to Lower Your DTI
- What Is a Debt-to-Credit Ratio?
- Why Is Debt-to-Credit Ratio Important?
- How Is Debt-to-Credit Calculated?
- How to Lower Your Credit Utilization Ratio
Taking out credit cards and loans can impact your financial profile in numerous ways, two of which are your debt-to-income ratio (DTI) and your debt-to-credit ratio. Credit scoring companies factor your debt-to-credit ratio into your credit score, and lenders often consider both your credit score and DTI when reviewing your application for new credit.
While both ratios examine your debt, they are unique because they measure different aspects of your financial situation. The difference between your debt-to-income and debt-to-credit ratios is that DTI compares your monthly debt payments to your income, while your debt-to-credit ratio compares your monthly debt payments to your total available credit.
What Is a Debt-to-Income Ratio (DTI)?
Your debt-to-income ratio provides a snapshot of your finances, comparing how much you owe each month with how much you earn. More specifically, your DTI is the percentage of your gross monthly income dedicated to paying your monthly debt payments such as a mortgage, other loans and credit cards. If you rent your home, DTI will include your rent payment. DTI is calculated by adding your fixed monthly payments on installment loans (mortgage, auto loans and personal loans, for example) to the minimum monthly payments on your revolving credit accounts (such as credit cards) and then dividing that number by your gross monthly income. More on this below.
Most of the time, your DTI ratio includes all your debts, but not when you are buying a home. In that case, the mortgage lender calculates front-end and back-end ratios.
- Front-end DTI: This calculation includes only your monthly housing expenses, such as rent or, if you own a home, your mortgage payment, mortgage insurance, property taxes and homeowners insurance. Generally, mortgage lenders prefer your housing expenses to account for no more than 28% of your total monthly income.
- Back-end DTI: By contrast, your back-end DTI includes all of your monthly debt obligations, such as loans and credit cards, as well as your housing expenses. Mortgage lenders typically want to see your back-end ratio below 43%, or even below 36% in some cases.
Why Is DTI Important?
Your DTI ratio is important because it helps lenders and creditors decide whether to approve your application for new credit, and what interest rate you'll receive. They rely on your DTI to show your ability to manage new monthly payments and repay any credit they approve.
Keep in mind, DTI limits can vary by lender and loan type. For example, many personal loan lenders prefer your DTI to be no more than 40%, while mortgage lenders often impose a maximum DTI limit of 43%.
Even if you don't plan on taking out a new loan or credit product, keeping track of your DTI can help you gauge your financial stability and track your debt. If you're struggling to manage your debt, consider seeking assistance from an accredited credit counseling organization, such as one affiliated with the National Foundation for Credit Counseling (NFCC).
How Is DTI Calculated?
To calculate your debt-to-income ratio, add up your monthly debt payments and divide the total amount by your gross monthly income. Your gross income is the amount you earn each month before taxes, insurance and Social Security are deducted. Here's the formula:
Debt / Income = Debt-to-Income Ratio (DTI)
So, for example, if your monthly take-home pay is $8,000 and you pay $2,000 per month in debt payments, your debt-to-income ratio is 25% ($2,000 divided by $8,000 = .25 or 25%).
How to Lower Your DTI
As a general rule, aim to keep your debt-to-income ratio at 43% or less, as this is the maximum DTI many mortgage lenders prefer. Even better, a DTI ratio of 36% or lower indicates to lenders you can likely afford new credit payments.
If your DTI ratio could use improvement, consider these steps to lower it:
- Reduce your debt by paying off your credit cards and loans.
- Increase your income by requesting a wage increase, volunteering for overtime or starting a new higher-paying job.
- Trim your discretionary spending such as canceling little-used memberships and subscription services.
- Consider taking out a debt consolidation loan to accelerate your debt payoff timeline.
- Don't take on any new debt, which could raise your DTI ratio.
What Is a Debt-to-Credit Ratio?
Your debt-to-credit ratio, also known as your credit utilization ratio, measures how much of your available revolving credit you're using. Revolving credit includes credit cards and lines of credit. It is open-ended, meaning you can continuously borrow as much or as little as you like—up to your limit—and you only pay interest on what you borrow.
Why Is Debt-to-Credit Ratio Important?
The FICO® Score☉ , the credit score used by 90% of top lenders, and other credit scoring models consider your debt-to-credit ratio to calculate your credit score. These models consider your utilization ratio for each credit card you own and collectively as part of your overall credit utilization ratio.
The weight these models place on your credit utilization rate is considerable; it accounts for roughly 30% of your FICO® Score. A debt-to-credit ratio above 30% may have a more negative impact on your credit score, as it indicates you may have a high level of debt and might struggle to pay back a loan. Aim to keep your credit utilization rate below 10% for top credit scores—especially if you're planning to apply for new credit—but the lower, the better.
How Is Debt-to-Credit Calculated?
Your debt-to-credit ratio is the total of all your revolving credit balances divided by the total of your revolving credit limits.
The formula is:
Balance / Limit = Debt-to-Credit Ratio
So, if you have two credit cards that each carry a $2,000 limit, and you owe $750 on one and $250 on the other, your overall utilization ratio is 25% ($1,000 divided by $4,000 = 0.25 or 25%).
You can use the same process to calculate your credit utilization ratio for each of your individual revolving accounts.
How to Lower Your Credit Utilization Ratio
A low credit utilization ratio can help you maintain a good credit score and may even improve your score. Here's how to lower your credit utilization ratio.
- Pay down your credit card balances by using a debt repayment strategy such as the debt snowball or debt avalanche method.
- Request a credit limit increase to lower your utilization rate by widening the gap between your credit card balance and your limit.
- Don't add more credit card debt, as increasing your credit card balances offsets any progress you're making to lower your debt-to-credit ratio.
- Spread your debt across multiple cards, since credit scoring models consider both per-card and overall credit utilization. One maxed-out card could negatively affect your credit score. You can lower your utilization rate on individual cards by spreading your debt between them.
- Keep credit card accounts open, even if you aren't using them much. When you close a credit account, you remove the available credit that comes with it. As a result, your debt-to-credit ratio could be higher, which can influence your credit score.
Monitoring Your Debt Is Essential
DTI and debt-to-credit ratios are different measurements, but both can influence a lender's decision to loan you money. A high DTI could suggest to lenders you're a risky borrower who might be hard-pressed to make new loan payments. Similarly, a high credit utilization ratio could harm your credit score and, consequently, your ability to qualify for new credit.
Clearly, keeping track of your debt is essential to maintaining a healthy financial profile. Consider reviewing your credit report and credit score for free with Experian to see how your credit utilization ratio is affecting your credit score, and what moves you can make to improve it.
