“It is used as an indicator of indebtedness and how tight your budget might possibly be,” said Greg McBride, chief financial analyst for Bankrate, a New York-based financial data provider.
A debt-to-income ratio (DTI) is calculated by taking a person’s monthly debt payments and dividing the total by the monthly income.
A lower percentage means that the consumer has a manageable debt level, which is an important factor when applying for a credit card, car loan or mortgage, said Bruce McClary, spokesperson for the National Foundation for Credit Counseling, a Washington, D.C.-based non-profit organization.
Figures in the 25 percent and 40 percent range are generally considered good while anything above 43 percent can cause issues when applying for certain types of mortgage loans, he said.
Here are some ways for consumers to lower their ratio if it's too high:
- One good way to maintain a healthy debt ratio is to avoid carrying a balance on your credit card or to quickly repay any debt, McClary says. If you have to carry debt from month to month, keep debt levels as low as possible, such as 20 percent of your credit limit. “That’s not only good for your wallet, it’s good for your credit score, too,” he said.
- Work out a plan to quickly pay down your debt. The best way is to focus on the high-interest debt that is costing the most to carry, McClary said. Make extra payments if you can or pay more than the minimum payment.
- Find ways to boost your income by taking on additional hours at your current job or finding part-time work. The ratio improves if you get a raise or a new job with a higher salary. "If the total of your debt payments exceeds 43 percent of monthly income, lenders get squeamish,” McBride said. “Aim to keep your total of payments below 36 percent of income, not only to get approved for the best terms but also to have a monthly budget that allows for sufficient saving and financial wiggle room.”
- Refinance into lower interest rates that will reduce your monthly payments.
- Pay off a couple of outstanding debts, particularly those with smaller balances and relatively high monthly payments, McBride said. “For example, if you’re down to the final $1,500 on your car loan, then wiping out that balance eliminates a payment that could be chewing up $300 or $400 per month or more,” he said. "That’ll help your debt ratio tremendously.”
- Avoid taking on more debt, such as making large purchases.
- Check your debt-to-income ratio on a regular basis.
- Lower your discretionary spending such as driving on toll roads, eating out, streaming services or entertainment such as concert tickets.
- Use your tax refund to pay down your debt and avoid spending it on a vacation or buying something you may not need.