Your debt-to-income ratio can help you understand what percentage of your income is allocated toward debt each month. It’s also one of several important financial indicators that lenders use to evaluate your application for credit, and how likely you are to repay a loan.
» MORE: What is debt?
What is your debt-to-income ratio?
Your debt-to-income ratio, or DTI, expresses the percentage of your before-tax monthly income that goes toward paying your monthly debts, like rent or mortgage, credit card bills, auto loans and student loans. It is a calculation used by lenders to determine your borrowing risk.
Thankfully, DTI is only one factor in determining whether you qualify for a loan. Your credit score, employment history, the size of your down payment, (if it’s a mortgage or car loan, for instance) loan term and financial assets are other factors that will also be considered.
You can calculate your debt-to-income ratio by dividing your total monthly debt payments by your gross monthly income and multiply the answer by 100. The result is your debt-to-income ratio percentage.
Let’s say your monthly debt payments total $1,200 and your gross monthly income totals $3,500.
$1,200 / $3,500 = 0.34, or a DTI of 34%.
This means approximately 34% of your gross monthly income goes toward debt payments.
What is a good debt-to-income ratio?
Canadian lenders generally look for a debt-to-income ratio that’s 42% or lower, though the actual maximum DTI to qualify for a loan will depend on the individual lender and the type of loan you’re trying to get.
A lower debt-to-income ratio generally means you have more income than debt. With a low DTI, you’re able to pay your debts and still have money left over for things like utility bills, savings, and entertainment. It also means that you’re more likely to be able to handle additional debt in the future.
A higher debt-to-income ratio means your debts take up a significant amount of your income, making it less likely that you have money for other expenses or the ability to take on more debt.
Why your debt-to-income ratio is important
Your debt-to-income ratio expresses how much of your income goes toward debt each month. Knowing this ratio may help you to better understand your financial health and whether you’re capable of taking on more debt at your current rate of income.
Knowing your DTI is most important when planning to apply for a loan, as it’s a factor lenders will look at when determining how likely you are to pay back the debt.
The limits of your debt-to-income ratio
Although useful your debt-to-income ratio doesn’t tell you — or a lender — everything about your financial health. Most notably, it doesn’t differentiate between high-interest debt, like credit cards, and lower-interest lines of credit.
It also only looks at your total debt payments each month; it doesn’t factor in unexpected or non-debt expenses, like groceries or utility bills. When considered in isolation, your debt-to-income ratio could suggest you have more flexibility to pay back debt than you actually have.
DIVE EVEN DEEPER
Debt can be divided into several types: secured and unsecured, good and bad. Other types of debt include credit card debt, student loans, medical bills and mortgages.
You can check your credit score and credit report for free by contacting Canada’s two main credit bureaus, Equifax and TransUnion, without hurting your credit.