How to consolidate debt with a high debt-to-income ratio
AA personal finance axiom states that the only people who can borrow money are those who don’t need it. The irony of this well-established truth hits especially hard those who have accumulated so much debt that they cannot use a consolidation loan to ease the burden.
However, there are ways to consolidate your debt even when your debt is high, as measured by your debt-to-income ratio.
Determine your debt-to-income ratio
The debt-to-income ratio, or DTI, is a key figure in personal finance. It shows the relationship between your monthly debt payments and your monthly income. It is expressed as a percentage.
Lenders use the DTI to make lending decisions. A lower DTI tells them that a borrower is less risky. This can affect interest rates and other loan terms, as well as the approval of an application.
To calculate your DTI, add up all of your monthly debt payments. Include credit cards as well as auto, student, personal and other loans. Include any alimony or child support payments that you are required to make. Do not include rent, insurance, gasoline, food, utilities, and other expenses not related to debt.
Now add up all your monthly income. Include salary, interest and dividends. Lenders vary, but the inclusion of alimony and child support payments is usually optional.
Then divide the total monthly debt payments by the total monthly income. Multiply the resulting decimal digit by 100 to get your DTI as a percentage.
How Debt Consolidation Works
Debt consolidation loans provide money to pay off other loans. Why borrow money to pay off your debts? Many reasons:
- A debt consolidation loan allows you to extend the time you have to pay off your debts. This allows you to make smaller payments. Among other benefits, it can relieve the stress of monthly end-of-month meetings.
- You may be able to get a lower interest rate on a debt consolidation loan. A lower interest rate can also mean lower payments and less stress. This is especially true if your existing debt includes credit cards. And it’s even more true if you’ve missed a payment on one or more credit cards. Card issuers typically charge punitive interest rates of up to 30% on late payers.
- Combining all of your debts into one makes it easy to keep records, pay bills and budget. It’s easier to track a single payment than it is to make multiple payments. This can reduce your risk of missing payments and incurring late fees and interest penalties. Paying on time also helps your credit score.
- A consolidation loan can help you pay off your debts faster. While the consolidation loan is likely to have a longer term than your existing debts, incurring less interest and fees could save you enough to allow you to make additional payments on your debts.
Consolidation loans work best when you have a good credit score, sufficient income to make the consolidated payment comfortably, and a commitment to repay your debts. They don’t work as well when the debt-to-income ratio is high. However, again, there are ways around this.
How High DTI Affects Debt Consolidation
Mortgage lenders generally offer the best terms to borrowers with an DTI of less than 43%. You can still get a mortgage with up to 50% DTI, but the interest and other charges will likely be higher.
Unsecured personal debt consolidation loans have stricter DTI limits. It usually takes a DTI of 36% or less to get the best interest rates and other terms. Many lenders do not lend at all to borrowers with DTIs above 43%.
Even if approved, a borrower with a high DTI may have to pay more interest on a debt consolidation loan than on current consolidation loans. This can make a debt consolidation loan a much less attractive tool for managing debt.
Debt consolidation options with a high DTI
Is there a way to get a debt consolidation loan with a high DTI? In fact, several options exist, including:
- Get a co-signer. If you have a friend or family member with good credit and low DTI and you secure your loan by co-signing, you can get an unsecured debt consolidation loan with a reasonable interest rate and favorable terms. . The potential downside is that you can damage your relationship with the co-signer if you don’t make the payments on time. This therefore only concerns borrowers with sufficient income and determined to pay their debts.
- Get a secured loan. It is important to know the difference between secured debt and unsecured debt. Most debt consolidation loans are unsecured, which means you haven’t provided any collateral that the lender can grab if you don’t make the payments. However, you can get a secured personal loan on favorable terms if you have collateral, such as a car or other asset. This makes you a low risk borrower from a lender’s perspective. However, you bear the additional risk of losing the asset you have deposited as collateral.
- Use a home equity loan. A home equity loan or home equity line of credit uses the equity in your home as collateral. The terms of home equity loans can be attractive. Again, however, you take additional risk. In this case, the risk is losing your home.
- Refinance in cash. Another way to leverage your home equity is to refinance your mortgage with a loan that is greater than the amount needed to pay off your existing mortgage. The excess cash can pay off other debts. The low interest rate and easy terms for withdrawal refinances can be tempting. Like the home equity loan, however, you risk losing your home if you don’t pay off your new mortgage.
- Credit card balance transfer. Credit card issuers are constantly offering introductory balance transfer offers at low to no interest for borrowers who apply for new cards. If you have a good credit score and your DTI is not too high, you may be able to get one of these cards and then transfer the balances from the high rate credit cards to the new one. This can save a bundle of interest. However, if you don’t pay off the balance on the new card by the end of the introductory rate period, you could incur interest charges anyway.
Lower your DTI
The least risky way to use a debt consolidation loan to pay off your debt when you have a high DTI is also the longest. That is, to reduce your DTI before taking out the loan. Here’s how to do it:
- Pay off your debts. It’s a classic Catch-22, that’s right. But to the extent that you can pay off some of your debt, you will improve your DTI. Maybe you could sell a mostly paid car, use the proceeds to pay off the car, and pay cash for a cheaper ride. Another option is to get a loan or even a gift from a friend or family member and pay off one or more of your debts. If not, you can try to eliminate unnecessary spending to free up money and then apply classic snowball or debt avalanche techniques.
- Earn more income. You can play with the other side of the DTI equation by increasing your income. Take a second job. Ask for a raise. Move to a new position that pays more. Doing overtime. Anything can increase your income and improve your DTI.
Alternatives to debt consolidation
If you just can’t get a debt consolidation loan no matter how hard you look, alternatives always exist. Here are a few options you might want to consider:
- Get credit counseling. Working with a credit counselor to budget and manage expenses is a wise move, regardless of your approach to reducing your debt. The best choices when it comes to credit counseling are members of the Financial Counseling Association of America or the National Foundation for Credit Counseling.
- Sign up for a debt management plan. This requires contracting with a company that will first work with your lenders to lower interest rates and waive late fees and other penalties. Then you will send a single monthly payment to the debt management company, which will make the repayments on your loans. Debt management plans also involve fees and require a commitment on your part to pay off your debts.
- Declare bankruptcy. If you can’t see a way to pay off your debts, seeking protection under Chapter 7 of the Federal Bankruptcy Code may require the sale of some of your personal assets, but will end most claims. A Chapter 13 filing gives you more time but still forces you to pay off your debts. Either approach means long term damage to your credit score.
- Try debt settlement. For a fee, debt settlement companies will try to convince your creditors to accept less than you owe in exchange for a lump sum payment. However, the fees can reach up to 35% of the amount owed. And, unfortunately, many debt settlement offers are outright scams, making them an option of last resort.
Getting a debt consolidation loan with a high DTI is not easy, but it can be done. It may cost more and take longer, but there are ways to deal with a high DTI. And if you take the long-term view and work to control your spending and maximize your income, you may be able to lower your DTI and be a more attractive borrower, or even pay it off without any debt consolidation loans.
Frequently Asked Questions
What are front-end and back-end DTIs?
Some mortgage lenders use an initial DTI, or housing ratio, which includes only the mortgage payment, mortgage insurance, and other housing costs. The DTI back-end includes mortgage debt, credit cards, auto loans, student loans, and other debts.
Will A Debt Consolidation Loan Help My DTI Ratio?
Normally, yes, by reducing your monthly debt payments.
Will debt consolidation hurt my credit score?
Using a debt consolidation loan to pay off your debts can temporarily lower your credit score. However, paying off your debts while staying up to date with your payments will help your score in the long run.
More from the advisor
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.