One of the most common reasons people are rejected for a credit card — even people with good credit — is a high debt-to-income ratio. If this happens to you, it’s important not to just shrug your shoulders at the rejection and move on. A high “DTI” is a red flag. It’s an indicator that you’re either in financial stress or you could get there pretty easily.
How to calculate debt-to-income ratio
Simply put, your debt-to-income ratio is the percentage of your income that’s being eaten up by your debt payments — credit cards, student loans, car loan, mortgage, etc. You usually calculate it on a monthly basis:
DTI = monthly gross (before-tax) income / monthly debt payments
Consider this scenario: Janet is lawyer making $60,000 a year, which comes out to $5,000 a month. Between her credit card, mortgage, and student loans, her monthly debt payments add up to $2,300. Her debt-to-income ratio, therefore, is:
DTI = $2,300 / $5,000 = 46%.
Ideally, your financial picture will be different from Janet’s, because the Federal Reserve generally defines a DTI of 40% or more to be a sign of stress. A DTI of 20% or less is considered low. Aim to keep yours below 30%.
For help figuring your debt-to-income ratio, use NerdWallet’s DTI calculator.
Why does a high DTI affect new credit?
A high debt-to-income ratio might not seem like a big deal if you’re paying your bills on time and not falling behind. But taking on too much debt relative to your income can have serious consequences.
For starters, a high DTI means a loss of income can quickly push you into crisis. Take Janet from our example above. With 46% of her income being consumed by debt payments, she’d be in deep trouble if she were forced to absorb a reduction in income — for example, if she were laid off and had to take a lower-paying job.
A high DTI is also a sign that you may already be living beyond your means. While debt payments can represent major portions of the typical household budget — including shelter (mortgage) and transportation (car loan) — there are plenty of ongoing expenses that still need to be covered: food, clothing, gas for the car, the electric bill and so on. The more of your income that’s going to debt payment, the less you have to pay day-to-day expenses. The possible result: You start putting those expenses on credit cards, pushing your debt (and your ratio) even higher.
Because a high ratio suggests someone living on the edge, or close to it, credit card issuers won’t be eager to extend you new credit. Lenders want to get repaid, after all. The greater your financial stress, the greater your chances of not paying back the money you borrow. So the greater your chances of being rejected for a credit card (or any loan).
Credit reports don’t include income information, so they don’t reveal your DTI in themselves, but they do show how much debt you’re carrying. Higher levels of debt can push down your credit score. And that can get you rejected right off the bat.
What should I do if my DTI is too high?
If you were denied a credit card because your debt-to-income ratio is too high, it’s time to shift into debt repayment mode. Again, it’s not just this particular credit card that you should be worrying about — if your debt level has risen to the point that you’re being denied new credit, you could be headed for a financial crisis. To start with dealing with your debt, consider these tips:
- Stop charging. To make real progress with debt repayment, you need to stop the bleeding.
- Transfer your balance to a lower-interest card. If you’re not paying interest through the nose every month, more cash will go toward the principal, so you’ll be debt-free faster.
- Cut, trim and slash. Take a hard look at your monthly budget and figure out where you can cut. Funnel your savings toward your debt.
Being denied a credit card because of a high debt-to-income ratio is serious. These steps can help you attack the problem.