Your DTI Ratio: What It Is, and How to Improve It

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Dear Money101:

I was trying to finance a car and was told that my DTI ratio was too high. What does that mean and is there something I can do about it?-Jamal, Georgia State UniversityYour DTI, or debt-to-income ratio, compares your debt payments with your income. Lenders, such as auto-finance companies, use your DTI to get an idea of how -- or if -- they believe you’ll be able to make your payments. It determines how much cushion you have in order to pay every month and still be comfortable.

For lending purposes, your DTI starts by adding together your current debt payments (monthly credit card bill, student loans, if any) and whatever your new car payment would be. Then, it considers your gross monthly income, or your income before taxes.

The general DTI equation is A divided by B, where A represents your monthly debt payments added together and B represents your monthly gross salary plus any other income or bonuses before tax. Divide A by B to calculate your DTI.

For example, say your monthly gross income is $2,500 and your monthly rent, credit card payment, and new car payment totals $1,000. In this case, your DTI would be $1,000 divided by $2500, or 0.40. Represented as a percentage, that’s 40%.If you are above 40%, you need to rearrange some things.

“Your DTI should be 36% or less when you add in monthly debt payments, including mortgage or rent,” says Heidi Malone, a certified financial planner with USAA, a financial-services company. “Without rent or mortgage, your monthly payment amount should be kept below 20%.”Be aware that even if you have a good credit report, there’s still a possibility that you may get denied for a loan.

“Banks are going to look at a collage of asset and liability information,” says John Augustine, the chief investment strategist at Fifth Third Bank. “That would include your score, calculations, and deposit relations. Also your relationship with the institution is important--how long and consistent your history is considered an asset.”In short, talk to the bank where you have accounts and keep your credit history clean.In order to improve your DTI, you may need to increase your income with a second job or a position that pays you more to make your DTI go down. Try and save as much as you can to put a bigger down payment on the car, thus cutting your potential monthly payment and raising your DTI.

You need to cut as much of your monthly debt as possible. Pay down credit cards and other debt. You also may have to get creative. “Banks are mostly looking at recurring debt, such as credit card payments,” explains Augustine. “You need to ask yourself, ‘Is there an asset that I don’t need that I could sell in order to raise cash to get my payment down?’”If you are hard-pressed for cash, you could try the Bank of Mom and Dad. “For young people, getting along with your family is often a good thing with circumstances of young people beginning to borrow,” says Augustine. “Approach it the same way that companies would an individual--can I move my loan off my balance sheet to a family member or another source?”That’s not to say that you should rely on family or friends to get you out of trouble, but if your situation is dire enough, a trusted person may work something out with you before you talk to the lender. The answer is always no unless you ask.Even if you are not trying to finance a car or a house, your DTI is important, if only to assess your current state of financial health. Plug in your numbers to show you where you stand. “Knowing your debt-to-income ratio is important on both sides of the loan,” says Augustine. “A person can control their spending in other areas if a bank tells a person that potentially, they’re borrowing too much and may be putting themselves at risk.”Making sure your situation is under control now can prevent wishful thinking years from now. “The more you are in debt, the less that you can put into savings for retirement or even just fun things you would like to do some day,” says USAA’s Malone.

It’s a simple formula: save more, spend less, and pay off your debt.

“It’s almost like dieting when you’re trying to lose weight--you have to burn more calories than you’re taking in,” says Malone. “In this case, you need to live within your means.”

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