The debt-to-income ratio is a formula showing your monthly debts, divided by your monthly income. It is generally used to determine if your finances are in good shape and what, if any, improvements can be made to have less of your monthly income go towards monthly debt. Your debt-to-income ratio is also used by lenders to determine if you are financially solvent (able to handle your short and long term financial plans) because they are more likely to loan to people who better manage their debt and overall liabilities.
By way of illustration, let’s say Rachel has a steady monthly income of $3,000 (or $1500 per paycheck) from her job as an accountant. She pays $200 per month towards her car payment, and she pays the minimum of $100 towards a credit card. Her debt-to-income ratio in this scenario is 10%. She has very good odds of being approved for a loan because she manages her debt well.
Her friend Reggie, on the other hand, works as a legal assistant and and has the same monthly income of $3,000. However, he pays $250 a month towards a high interest credit card; $450 a month towards a student loan; and has a car loan of $375 a month. His debt-to-income ratio is 36%.
While Rachel has a manageable debt-to-income ratio, Reggie’s might be concerning to a lender because it shows that a lot of his income goes towards existing debt. The lender might give him less than favorable terms for a loan or might not loan to him at all until he can bring down his debt-to-income ratio.