Someday, you’re probably going to need a loan to purchase a car or a home. Even if that day feels far away right now, you can still learn how lenders—like credit unions and banks—determine how much they’re willing to lend you, and then take steps to put yourself in the strongest borrowing position for that “someday.”
When applying for a loan, your credit score is a large factor in determining what size loan and interest rate you’re approved for. Your score is based on multiple elements, like length of credit history, on-time payment history, and amount owed. Once your credit “worthiness” has been established (meaning you have a high enough credit score to meet the lender’s standards), the lender then looks at what size loan and loan payments you can reasonably afford. Affordability is largely determined by your debt-to-income ratio, or your DTI.
It’s important to note that although a lender may feel you can reasonably take on a certain amount of debt, you are still the expert on your living expenses and budget. It may be in your best interest to not borrow the maximum loan amount you are approved for, so you can continue to pay all of your expenses comfortably. As a financial rule of thumb, you should never rely completely on a lender’s opinion of how much you can afford—they won’t be the one going without electricity, food, or gas in your car if you can’t pay your bills because your monthly loan payment is too high.
Back to figuring out your DTI. Your DTI is based on a simple formula: monthly gross debt divided by monthly gross income. For example, if your monthly gross income is $3,000, and you pay $1,500 in monthly bills, your debt-to-income ratio is .50, or 50 percent ($1,500/$3,000). Gross income is how much you earn before deductions like taxes, wage garnishments, or child support are removed. Monthly gross debt refers to your recurring monthly debt—the minimum payments due for things like a vehicle loan, credit cards, cell phone bill, rent, and student loans. Monthly grocery bills, daycare expenses, restaurant tabs, and medications aren’t included in your DTI.
To help account for those expenditures outside of recurring monthly bills—the food, fuel, and other expenses we mentioned earlier—lenders set the magic debt-to-income ratio at 43 percent for most conventional loans. If more than 43 percent of your monthly gross income is tied up in recurring bills, lenders will likely not be willing to grant you a car loan or mortgage.
If your DTI is above 43 percent and a lender is still willing to give you a significant loan, it will be at a very high interest rate, which should be avoided.
If you plan to apply for a loan in the future, calculate your DTI and take a meaningful look at your ratio. If you’re over 43 percent, it’s time to create a budget that will bring you within this optimal DTI number. Consider credit consolidation or eliminating expenditures (like a little-used gym membership, eating out regularly, or entertainment subscriptions). When you understand what you can comfortably afford and how a lender will judge your credit worthiness, you can approach any loan application with confidence and understanding.