Do you know what your debt-to-income ratio is?
The term itself is fairly self-explanatory: a debt-to-income ratio, or DTI, is the relationship between how much you owe to lenders and how much you make. Lenders use this number to determine whether you can afford the payments on a loan.
What Counts Toward Your Debt-To-Income Ratio?
Lenders usually calculate your DTI using your monthly income and debt payments. Recurring monthly bills and expenses, including utility bills and what you spend on food, don’t count.
As far as your DTI is concerned, lenders only care about recurring debts. Those are the obligations that you pay off over time, like student loans or mortgages.
Credit card payments count only if you’re paying off a balance. If you pay your card down to zero every month, it doesn’t count as recurring debt. (Note that the term “recurring” refers to the payments, not to the debt itself.)
Why Does Your Debt-To-Income Matter to Lenders?
Your debt-to-income gives lenders an idea of the stability of your financial situation. The higher your DTI, the more of your income goes toward repaying your debts. If your income drops or your routine expenses go up, you’ll struggle more to pay your debts.
Lenders don’t like to offer new loans to people who are already struggling. It’s important to keep your DTI down so that if you do find yourself in need of a loan, you’ll find a lender more easily and get better rates when you do.
What is a Good Debt-To-Income?
Ideally, you should aim for a debt-to-income of 35 percent or less. This indicates that you’re managing your debt well and spending less than you make.
A DTI of 36 to 49 percent is less attractive to lenders. It means you’re getting by, but you’re less able to handle unexpected expenses like medical or legal bills. A lender might need more proof that you can afford a loan.
A DTI of 50 percent or less will make it difficult to get a loan. More than half of your income is already allocated to paying off your debts, so your disposable income is probably very low. You may even be spending more than you earn.
Take a moment to calculate what your debt-to-income is now. Start with your monthly gross income, then divide by how much you pay every month toward debts. Feel free to use an online DTI calculator if you need some more guidance or structure.
Repairing Your Debt-To-Income Ratio
It’s never a bad idea to work on your DTI, whether that means keeping it below 35 percent or getting it there. Of course, anything that involves paying off debt is easier said than done.
For homeowners, one of the most straightforward ways to repair your DTI is to tap your home equity.
Good Debt and Bad Debt
Not all debts are created equal. Your mortgage is generally considered to be good debt because it has the potential to increase your net worth. Every time you make a payment, you build equity, meaning that you can count more of your home’s value as an asset.
You can use the equity that you’ve built up to pay off your bad debts—credit cards and personal loans—and improve your debt-to-income. That said, equity isn’t cash. It’s the monetary value of your home, so you can’t use it as currency.
What you can do is tap your equity. There are a few ways you can do this:
- Take out a home equity loan or line of credit. A conventional loan is often better in this case because you get your equity as a lump sum instead of as an approved borrowable amount like you’d get with a line of credit. This option is more difficult to pursue if your debt-to-income is high.
- Refinance your mortgage with a cash-out option. You get a new mortgage with new terms, but instead of just borrowing the amount you have remaining on your mortgage, you add some of your equity to that total. That cashed-out equity doesn’t count as income, but you can use it to pay off your bad debts—if you can get approval for a loan with a high debt-to-income.
- Sell your home. This might be your only option if your DTI is high since it doesn’t involve borrowing. Fear not, though—selling doesn’t automatically mean that you’ll have to move. Not anymore.
How to Leverage a Sale-Leaseback
When you’re struggling financially, the emotional and financial upheaval of moving is the last thing that you want.
That’s why you should consider a sale-leaseback. It’s just what it sounds like—you sell your home to to a company, which pays you an agreed-upon amount for it. The difference is that you don’t have to move out. Instead, you become a tenant, paying monthly rent until you’re ready to buy back your home or move.
With a sale-leaseback, you get the money from the sale as cash, free and clear of obligations. You can use your money any way you want, including paying off your credit cards, personal loans, and other “bad” debts. Your debt-to-income ratio is able to improve with no disruption to your life.
What Would You Do With a Great Debt-To-Income Ratio?
If your DTI was more attractive to lenders, what could you afford to do?
- Make improvements or additions to your home
- Move to a custom-built dream home
- Get a more reliable vehicle
- Save more for retirement or a child’s education
- Take out a business loan and start or grow your business
The options are endless, but they all start the same way: with your decision to make our assets work for you.
It’s important to understand what is debt-to-income ratio and why it matters. If you’re struggling with your finances and want to improve your debt-to-income ratio, talk to a financial consultant to figure out your options. If you’re looking for an alternative, a sale-leaseback program can potentially help you accomplish your goals without having to leave the home you love. By this time next week, you could be well on your way to a better DTI and more financial freedom.