When applying for a loan there are several factors that lenders will consider when determining what you may qualify for.
Each lender has their own criteria, but generally speaking, they are looking to see if your outstanding debt plus any new debt can be supported by your income so they can evaluate the how likely it is that you will be able to repay the loan. The considerations that are most important in determining your creditworthiness include:
Your personal credit history and "credit score"
Amount you are looking to borrow
Income vs. your recurring debt obligations or your debt to income ratio or "DTI"
Your debt-to-income ratio (DTI) – how much you pay in debts each month compared to your gross monthly income – is a key factor when it comes to qualifying for a loan. Your DTI helps lenders gauge how risky you’ll be as a borrower.
*Lenders typically will require a "debt to income ratio" of 36% or less
How Do I Calculate My Debt-To-Income Ratio?
To calculate your DTI ratio, add together all of your monthly debts, then divide them by your pretax, or gross, income.
The only monthly payments you should include in your DTI calculation are those that are regular, required and recurring. Remember to use your minimum payments required – not the account balance or the amount you typically pay if it is more than the minimum.
Also, when applying for credit individually, you will only include your income and portion of debts you are responsible for. (So, if you share a $2,000 mortgage or rent payment with someone, you would include $1,000 for your portion.) If someone else is going to be added as a co-borrower and applying with you, then they will add their income, as well as any additional/separate debts on their portion of the application)
Example of debts that are typically included in DTI:
Your rent or monthly mortgage payment
Auto loan payments
Student loan payments
Credit card payments
Personal loan payments
Here’s an example showing how to calculate your DTI ratio.
Mortgage (portion you are responsible for): $800
Student loan minimum payment: $150
Credit card minimum payment: $125
Auto loan minimum payment: $175
In this case, you’d add $800, $150, $125 and $175 for a total of $1,250 in minimum monthly payments.
Step 2: Divide Your Monthly Payments By Your Monthly Gross Income
Your monthly gross income is the total amount of pre-tax income you earn each month.
Once you’ve determined the total gross monthly income, simply divide the total of your minimum monthly payments by your monthly gross income.
In this example, let’s say that your monthly gross household income is $4,500. Divide $1,250 by $4,500 and you get .30, or 30%. That means your DTI is 30%.
What do I do if my DTI is too high?
If you calculate your DTI only to find out that your debt to income ratio is exceeding 35-40%, there are a couple of options you might consider to impact your DTI in the short term:
Pay off smaller debts: If you can afford it, pay off your smallest outstanding debt in full. Your DTI will immediately be lowered.
Add a co-borrower: If your borrowing $10,000 or more, adding a spouse or partner can be a helpful strategy. The lender(s) will calculate your DTI using both of your incomes and debts. If your partner has a low DTI, you can lower your total DTI by adding them to the loan. However, if your partner’s DTI is comparable to or higher than yours, then adding them to the loan may not help your situation.