When you’re trying to borrow money – and that includes applying for credit cards – it pays to know your DTI, or debt-to-income ratio.
Your DTI presents a snapshot of what your debt looks like in relation to your income, and it helps lenders – especially mortgage lenders – see in a single number how easily you’ll be able to handle monthly payments on new debt.
Calculate your DTI by dividing your total monthly debt payments (including mortgage, student loans, car loans, and minimum credit card payments) by your gross monthly income (total pay before taxes and other deductions – like 401(k) contributions are taken out). The result shows you what portion of your monthly income is gobbled up by debt.
And, as you might expect, the lower your DTI, the better. When your DTI is too high, it can be tough to keep up with debt payments…and that puts you at a higher risk for late or missed payments, or even default. It also limits the amount of money you’ll have available for your other monthly expenses, savings, and fun money.
Let’s take a look at some numbers…
Monthly gross income is $6,250.
Monthly debt payments include:
$1,600 mortgage payment
$300 student loan payment, and
$200 minimum credit card payment
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Total monthly debt payments = $2,100.
The DTI would be calculated like this:
$2,100/$6,250 = 0.336, or 33.6%
That number looks pretty good to lenders, so they’d let you borrow even more money. But there’s a really big catch no one talks about: The way DTI gets calculated that could leave you in serious financial trouble.
DTI based on gross income is the number creditors look at, and it’s an important number to know…but it’s NOT the best number for you when you’re making financial plans and setting financial goals.
Why? Because you don’t have your gross income to work with – you just have your take-home pay. So using gross income paints a slightly rosier picture of how much of your budget is really going toward debt payments.
That $6,250 of gross income would probably look more like $4,000 in monthly net income (take-home pay). And recalculating that DTI based on net income looks very different…
Monthly gross income is $4,000.
Monthly debt payments include:
$1,600 mortgage payment
$300 student loan payment, and
$200 minimum credit card payment
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Total monthly debt payments = $2,100.
The DTI would be calculated like this:
$2,100/$4,000 = 0.525, or 52.5%
That 52.5% means more than half of your paycheck is going toward debt…and that’s before necessities like food, electricity, gas, and doctor bills. And that’s before you take out additional loans, adding more to your monthly debt payments.
Bottom line: Before you think about borrowing money, figure out a comfortable level of net income DTI – what you’d feel secure owing every month based on your take-home pay and your other expenses. And no matter how much a lender offers to give you, don’t take more than your real budget can spare.