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How to Lower Your Debt-to-Income Ratio to Get a Consolidation Loan
By Cassandra Journigan MONEY RESEARCH COLLECTIVE
Are you, like so many others, stumped when it comes to personal finances and managing your debt? One way of dealing with debt is by understanding and dealing with your debt-to-income ratio (DTI).
Your DTI compares your total monthly debt load against your gross monthly income. Potential lenders can judge your ability to repay them when they weigh your debts against your income. You can also use your DTI to know whether you need to take measures to get your debt under control.
With an average debt-to-income ratio, you may be able to get a debt consolidation loan, eventually enabling you to become debt-free. These loans merge several of your debts into one bill, minimizing your monthly payments. Often, these loans carry lower interest rates than those you’re paying, allowing you to pay your bills more easily.
In this guide, you’ll learn about what a debt-to-income ratio (DTI) is, how to lower it and what a debt consolidation loan can do for your credit health.
Understanding the debt-to-income ratio
With an ideal debt-to-income ratio, a lender is assured you can repay your loan. Your DTI can mean the difference between rejection and approval for loans such as mortgages, auto loans and personal loans.
Its purpose
Lenders often use DTI when deciding whether to loan you money. When you keep your DTI within a reasonable range, your lender can feel confident in your ability to pay your debt.
Lenders consider your credit score as well, which also indicates the likelihood that you will repay your loans. It’s based on information found in your credit reports, including credit activity and payment timeliness. Lenders use your credit score and DTI to determine your interest rate and how much you can borrow.
Your credit score is based on information provided to consumer reporting agencies. These agencies, also called credit bureaus or credit reporting companies, compile reports from information supplied by creditors.
What’s an ideal debt-to-income ratio?
According to the credit reporting agency TransUnion, the ideal DTI is around 35% or lower. Both Experian and Equifax, the other two main credit bureaus, say most lenders look for a DTI of 43% or less before approving a mortgage. The lower your debt-to-income ratio, the more likely you are to be able to repay your debts and the more likely you are to be approved for a loan.
The debt-to-income ratio formula
Your DTI includes all monthly debt payments, including rent or mortgages, auto loans, student loans, credit card debt using the minimum payment due, alimony, child support and other obligations. That figure is divided by your income.
To calculate your DTI, add up all your monthly debt payments and divide that total by your gross monthly income. For example, if you owe $1,000 for your monthly mortgage payment, $250 on your various credit cards and $250 for your car loan, then the debt you pay each month comes to $1,500. With a gross income of $4,500, your DTI is 33%.
Use this simple formula to find your debt-to-income ratio:
Monthly Debt Payments ÷ Gross Monthly Income = DTI
You can multiply this number by 100 to get a percentage. When calculating your DTI, keep in mind that monthly debt payments normally don’t include food, clothing, utilities or fuel expenses. Additionally, your gross income is all income before taxes and other deductions.
Plan to check your debt-to-income ratio calculation often. An online debt-to-income ratio calculator makes finding your DTI easy.
Effective ways to lower your DTI ratio
A lower DTI will help you obtain better interest rates. Here are some ways to help minimize your debt-to-income ratio.
Pay more toward your debts every month
It’s always the best policy to pay your debts on time. And, if possible, to pay more than the minimum amount due. Drawing up and maintaining a budget is the first step in figuring out how much you can pay toward your debts each month. When creating a budget, be sure to take into account expenses that you pay less frequently, such as annual subscriptions.
Paying more than the minimum balance reduces your credit and loan balances faster. Here are two common methods:
- Pay off your biggest debt first: Make minimum payments on all credit debts and loans except for the one with the highest balance or interest rate. Put anything extra in your budget onto that one credit card or loan payment. Once that bill is completely paid off, follow the same procedure with your following highest account. Continue this process until all your debt is paid off.
- Pay off your smallest debt first: Make minimum payments on all credit debts and loans except for the one with the lowest balance. Once that is paid off, stack the amount you were paying on top of the minimum due on the next smallest bill, continuing until all credit cards and loans are paid off. If possible, don’t use credit cards while attempting to pay them off.
Increase your monthly income
If your monthly personal budget doesn’t allow you to make any extra payments on your debts, you might want to consider finding ways to increase your income. You may be able to lower your DTI by asking for a raise or asking to work more hours. You may choose to search for a job that pays more or pick up a side hustle and dedicate all your extra money toward paying off your debt.
You can also sell items you own but don’t use. Garage sales and consignment shops are custom-made for such a strategy, as well as selling online through sites like eBay and Etsy.
Decrease your monthly expenses
You may also choose to raise cash by cutting back on unnecessary expenses. Common strategies include eating out less often, reducing online shopping, canceling unused subscriptions and shopping second-hand. Do you really need that cup of joe from your local coffee shop? Spending $3 a day, five times a week means you’re down an extra $60 that you could more effectively use to pay off bills.
Another practical approach is to make a list of items you need before you go shopping and stick to it. Alternatively, you can shop the sales and stock up on things you use frequently. Many grocery stores have apps that offer access to coupons and steeper discounts.
While at home, you can cut down on your utility bill by turning off lights, computers and TVs while they’re not in use. The U.S. Department of Energy suggests setting your thermostat back 7o to 10o Fahrenheit for eight hours daily to save up to 10% on your electric bill. When you buy new appliances, look for the Energy Star to save even more on utilities.
Negotiate a lower interest rate
Some people find success in negotiating with their debt collectors, or creditors, to ask for a reduction in interest rates to pay off debt faster. This strategy can succeed even with bills that have gone into collections.
Debt collectors buy debts for a fraction of what is owed and may be open to negotiating a smaller amount in exchange for prompt payment. Before you call, be sure to know the original creditor’s name, the total amount of the bills in collection and the date they became past due.
Negotiating these amounts and keeping up the payments will eventually improve your credit score.
Maintain a low credit utilization ratio
Your credit utilization ratio is the amount of credit you owe compared to your available credit. Strategies to maintain a low ratio include paying down your existing balances early, applying for a credit limit increase and keeping unused credit cards open. Your credit utilization ratio is a large component of your credit score, so it’s essential to keep it low.
Other ways to improve your credit score include:
- Paying your bills on time.
- Applying for credit only when necessary.
- Checking your credit score. Every year, consumers are allowed one free report from each of the three major agencies: Equifax, Experian and TransUnion.
If you’re having a particularly hard time with your finances, you may fall behind in payments and end up in collections. This can show up on your credit report and indicate high risk to lenders, so it’s a good idea to see if you can remove collections from your credit report. One possibility is to contact a credit repair agency.
A creditor may have written off your past-due account as a charge-off. While this temporarily removes some financial pressure, it comes at a cost to your creditworthiness. In such a case, your creditor may sell your account to a collections agency. In this case, you still must pay, but you may be able to negotiate terms you can comfortably afford.
These actions remain on your record for seven years, but it is possible to get them removed early. Creditors may have options to remove charge-offs such as an adjustment or pay-off amount.
Don’t take on new debt obligations
While you’re working to improve your DTI ratio, don’t take on new debt. Taking on new debt raises your DTI ratio, negatively impacts your credit score and can increase your financial stress level. This includes taking out loans or opening new credit cards to pay off existing debt. Before buying something on credit, ask yourself if you need it and whether you can save enough cash instead.
What a debt consolidation loan can do for your DTI ratio
Sometimes, despite all you’ve done, you still face more debt than you can handle. It may be time to seek a debt consolidation loan. These loans gather many of the debts you owe into one single loan payment, reducing your monthly payments. What’s more, they often offer lower interest rates than those you currently pay.
To get a debt consolidation loan, you will likely have to work on your DTI first. There are some lenders who will accept your application even if you have a high DTI, but it’s not common and you may have to pay higher rates.
Consolidation loans can also help reduce your DTI ratio by lowering your monthly debt payments. Paying those debts while remaining current with your charges will eventually raise your credit score.
What is borrowing risk?
A borrowing or credit risk relates to borrowers’ ability to repay their loans. Lenders consider the five Cs:
- Credit history
- Capacity to repay the loan
- Capital
- Conditions attached to the loan
- Collateral associated with the loan
You could be considered a credit risk even though you’re working toward a better credit score. However, you may need money before your credit score has increased. In such a case, you may need to seek a loan with bad credit.
Don’t worry — they do exist. These lenders will still use your credit history to decide whether or not to provide you with a loan. That, in turn, will help them determine the amount they will lend and the interest rate you will pay.
The connection between debt-to-income ratio and financial health
Debt-to-income ratio is a strong indicator of financial health. If you keep your DTI low, lenders know that you’re more likely to be able to pay off your loans.
A high DTI, on the other hand, can ring warning bells for creditors. It can indicate that an unexpected expense or stroke of bad luck might render you unable to fulfill your debts.
Keeping your debt-to-income ratio low means you’re more likely to be approved for loans, including debt consolidation loans, and with lower interest rates to boot.
The road to sound financial health starts with keeping your credit score high and your DTI low. If you want to pay less for every major item you purchase, make high monthly debt payments, spend less than you take in, try negotiating a lower interest rate, maintain a low credit utilization ratio and don’t take on new debt. When your debt feels overwhelming, a debt consolidation loan might be able to help.