What Debt Ratio Score Is Considered Good?

A debt ratio is a financial metric lenders use to assess your capacity to take on new debt, such as a mortgage or car loan. This metric is a ratio expressed as a percentage, showing how much of your monthly income is already committed to existing debt payments. It is an indicator of your financial health.

Calculating Your Debt-to-Income Ratio

To determine your debt-to-income (DTI) ratio, first compile a list of all your recurring monthly debt payments. These obligations include rent or mortgage payments, minimum credit card payments, auto loans, student loans, personal loans, and any court-ordered payments like alimony or child support. Do not include monthly living expenses like groceries, utilities, or insurance premiums.

Next, find your gross monthly income, which is your total earnings before taxes or deductions. The calculation is to divide your total monthly debt by your gross monthly income. For example, if your monthly debts are $2,000 and your gross monthly income is $6,000, your DTI ratio is 33% ($2,000 ÷ $6,000 = 0.33).

Interpreting Your Debt-to-Income Ratio

Lenders use your DTI ratio to determine your ability to manage new loan payments. A lower DTI suggests a healthy balance between your income and debt, making you a less risky borrower and increasing the likelihood of loan approval.

A DTI ratio of 35% or less is considered ideal by most lenders. Borrowers in this range are seen as having ample income to cover existing obligations and handle new payments. This often results in more favorable loan terms and interest rates.

Ratios between 36% and 43% are deemed manageable, but they can raise concerns for lenders. While conventional loans may be approved in this range, it signals less capacity for financial setbacks. For mortgage lending, a guideline is the “28/36 rule,” suggesting no more than 28% of gross monthly income goes to housing costs and no more than 36% to total debt.

The 43% level is a benchmark for lenders, as it is a widely used industry standard for assessing risk. A DTI of 44% or higher is classified as high-risk, making it more challenging to secure a conventional loan. This is because a high DTI indicates that a large portion of your income is already allocated, leaving little room for a new loan payment.

Some government-backed loans, such as FHA loans, may allow for a DTI up to 50% if the applicant has strong compensating factors. These can include a high credit score or significant savings.

Other Key Debt Ratios

Another metric is the debt-to-asset ratio, which offers a different perspective on your financial health by measuring total liabilities against total assets. It is calculated by dividing your total debts, including all loan balances, by the total value of your assets, such as cash, investments, and real estate.

The debt-to-asset ratio gauges overall solvency and net worth, revealing the extent to which your assets are financed by debt. For instance, a ratio of 0.4 means that 40% of your assets are financed by creditors. This provides a broader view of your financial structure and long-term stability.

Strategies to Improve Your Debt Ratio

Improving your DTI ratio involves either reducing your total monthly debt or increasing your gross monthly income. A direct way to lower the ratio is to reduce your debt by making extra payments on your loans. Focusing on paying down loans with the highest interest rates or the smallest balances first are effective strategies.

You can also avoid taking on new debt, especially in the months before a major loan application for a mortgage. Postponing large purchases that require financing can prevent your DTI from increasing and keep your financial profile strong.

Increasing your income is the other way to improve your DTI. Seeking a raise, taking on part-time work, or developing a side business can boost your gross monthly income. Even a modest increase in earnings can improve your DTI ratio by expanding your capacity to manage debt payments.