According to the Federal Reserve, Minnesotan’s household debt-to-income(DTI) ratio for 2019-2022 stood at 1.286.1 That means that for every dollar a typical borrower in Minnesota uses to repay debts, they have about $1.30 in income.
The national average debt-to-income ratio is 1.51, putting our state below the national average, but exactly what does that mean, why should we care, and what can we do about it?
How Do You Calculate DTI Ratio?
Calculating your ratio isn’t complicated. To calculate your DTI — debt-to-income ratio — total your monthly debt payments and, separately total your gross monthly income, which is the amount of money you earn before any deductions, including taxes. Then, divide your total debt payments by your household’s gross monthly income. This simple equation will give you your debt-to-income ratio as a decimal. Multiply this number by 100 to get a percent.2
This gives a quick snapshot of your monthly finances by focusing on how much money you have after you’ve paid your monthly bills. With all of the ways to measure financial health, the debt-to-income ratio might seem like just one more statistic. In reality, though, this number is an important indicator of financial health.
Your DTI ratio has real-world implications. For instance, it can affect your access to lines of credit because lenders use it to judge your ability to make monthly payments. This is because having a higher debt-to-income ratio might indicate that a borrower would struggle to meet their monthly obligations. This can make you seem riskier to lenders.
Here are two examples:
- Household 1 has a $1,600 mortgage payment, a $300 car loan, and a $100 credit card payment totaling $2,000. The household’s gross monthly income is $6,000. Their debt-to-income ratio is $2,000/$6,000 or .33. Multiply this by 100 to get a percent, which in this case is 33%.
- Household 2 has a $1,600 mortgage payment, a $500 car loan, and total credit card payments of $1,000, and miscellaneous other monthly payments of $400, totaling $3,500. Their gross monthly income is $7,500. Their DTI is .50, or 50%.
Although Household 2 earns more than Household 1, they have more debt, which makes them riskier than Household 1.
What does DTI Mean for Borrowers?
When you have a lower debt-to-income ratio, lenders see you as less risky. This can make it easier for you to gain access to credit, from opening credit cards to getting a mortgage. In some instances, you may also qualify for improved terms, like lower interest rates. And while other factors are included in credit decisions, like your credit score, it’s a good idea to understand your credit to debt ratio and work to improve it.
When adding up your monthly debts, keep in mind that some lenders include living expenses like utilities and auto insurance, and some do not.. If you are just trying to get a general idea of your DTI, calculate it both ways.
What is a ‘Good’ Debt-to-Income Ratio?
According to the standards used by many lenders, a debt-to-income ratio under 36% is preferred. Other lenders use 43% as a determination for qualified mortgages.2, 3, 4However, each lender sets its own standards and uses other financial measures to make decisions on creditworthiness. This can include your ratio of debt to income, along with your credit score, how long you’ve been at your job and additional factors. In general however, having lower debt in comparison to your income is seen as favorable when it comes to getting a mortgage or other line of credit.
How You Can Improve Your DTI
Fortunately, you can take steps to improve your DTI so that you’re in a better position when it comes time to apply for credit. Bringing more money in each month is one way to do this, but you can also improve your DTI by paying off debts including credit cards, car loans, and any debt you make monthly payments on.
There are several ways to approach reducing debt. One way includes paying off debts that have higher monthly payments first. This method can quickly free up monthly income and improve your DTI. Another method includes paying off lower debts first and applying that payment to larger debts. Both methods may also have positive implications for your credit score.
No matter how you decide to approach it, improving your debt-to-income ratio is an important step in preparing for a mortgage or other line of credit. And if you aren’t sure where to start, or think you may have other issues that could make it difficult to get a home loan, consider working with an experienced financial advisor like Lundervold Financial. We can evaluate your specific needs and give you advice based on your unique situation.
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Sources
1 Board of Governors of the Federal Reserve System. 1999-2020. “State-Level Debt-to-Income Ratio, 1999-2020.” Accessed Feb. 16, 2021.
2 Consumer Financial Protection Bureau. Nov. 15, 2019. “What Is a Debt-to-Income Ratio? Why is the 43% Debt-to-Income Ratio Important?” Accessed Mar. 16, 2021.
3 Consumer Financial Protection Bureau. Dec. 10. 2010. Final rule. “Qualified Mortgage Definition under the Truth in Lending Act (Regulation Z): General QM Loan Definition.” Accessed April 20, 2021.
4 Julia Kagan and Marguerita Cheng. Investopedia. Aug. 28, 2020. “28/36 Rule.” Accessed Mar. 16, 2021.
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