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Before approving you for new credit, creditors will likely first examine your credit report, your credit score and something called a debt-to-income ratio – commonly referred to as DTI.
While all of these factors help to show your likelihood of repaying the borrowed money, your DTI shows whether or not you have the means to repay the loan. As stated, the “debt / revenue” ratio is the amount of debt you have in relation to your revenue.
Creditors examine your DTI to see how much of your monthly income is earmarked for the debt obligations you already have. A low DTI indicates that you earn more than you owe, while a high DTI means that a larger part of your paycheck goes towards paying off your debts.
How to calculate the debt-to-income ratio
To calculate your DTI, divide your total monthly payments (credit card, rent or mortgage accounts, car loan, student loan) by your gross monthly earnings (what you do each month before tax and any other deductions) .
For example, here’s what your monthly payments might look like:
Mortgage: $ 1,500
Car loan: $ 500
Student loan: $ 320
Minimum payment by credit card: $ 180
Total monthly bill payments: $ 2,500
If your monthly debts total $ 2,500 and your gross monthly income is $ 5,000, the DTI calculation would be: $ 2,500 / $ 5,000 = 0.5. To obtain the ratio as a percentage, you must then multiply 0.5 x 100 = 50%. Your DTI would be 50%.
The ideal DTI varies depending on the lender, the type of loan and the loan amount. Generally, a DTI of 20% or less is considered low and 43% or less is the rule for obtaining a qualified mortgage, according to the CFPB. Personal loan lenders tend to be more tolerant of DTI than mortgage lenders. In all cases, however, the lower the DTI, the better. A lower DTI shows that you do more than you should, and therefore can take on more debt while maintaining the monthly payments you already have.
How to improve your debt / revenue ratio and help your credit score
Your income is not included in your credit report, but lenders often ask you to include it in any loan application, in addition to providing proof of income.
Since your DTI does not appear on your credit report, it will not necessarily affect your credit. The actions you take to reduce your DTI, however, can, in turn, help your credit score.
An obvious way to lower DTI is to reduce the total debt burden. If you can, pay off credit card balances or any other loans, or at least withdraw the balances when possible. Getting rid of outstanding credit card debt also helps to reduce the credit utilization rate, which analyzes how much of the available credit you use. A low utilization rate is essential to having a good credit score and represents 30% of the score calculation.
A debt consolidation loan can make it easier for you to reduce your debt more quickly by simplifying your monthly credit card payments on a single invoice. Qualifying for a lower monthly payment can also help lower your monthly debt obligations and thereby lower your DTI. We classify the Marcus by Goldman Sachs personal loan as the best for debt consolidation because it does not offer origination fees, prepayment fees and late fees.
Track your credit score as your debt-to-revenue ratio improves
Since your credit score plays a big role in whether or not to approve a new credit, keeping track of it is just as important as working to improve your DTI.
Credit monitoring services help you stay alert of any changes to your credit by notifying you in real time, as well as helping you to detect fraud in advance. CreditWise® from Capital One is a free credit monitoring service open to everyone – regardless of whether you are a Capital One cardholder. It also offers dark web scanning and social security number tracking, as well as a scoring simulator tool credit. When planning to pay off any debt in the hope of improving your DTI, you can see how these efforts also help your credit score.
Increasing your income is another way to improve your DTI. Consider asking for an increase in work, finding a side job that you can do at night or on the weekends, or quitting your job for one that pays you more.
Remember that when you are approved for that new credit that you want so much, your DTI will increase because you are taking on more debt. This may influence your ability to borrow more in the future.
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Editorial Note: The opinions, analyzes, reviews or recommendations expressed in this article are the sole responsibility of the CNBC Select editorial team and have not been reviewed, approved or otherwise endorsed by third parties.