Understanding Debt-to-Income Ratio (DTI) for Mortgage Applications
When you’re looking to apply for a mortgage, one of the factors that lenders will consider is your debt-to-income ratio (DTI). Your DTI is a percentage that compares your monthly debt payments to your monthly income. A high DTI could prevent you from being approved for a mortgage, so it’s important to understand what it is, how it’s calculated, and how it can be improved.
What is Debt-to-Income Ratio?
Your DTI is a calculation that shows how much of your monthly income goes towards debt payments. Your lender will use this information to determine if you’re capable of making your mortgage payments on time for the term of the loan.
To calculate your DTI, you need to add up all of your monthly debt payments (such as credit card balances, car loans, student loans, etc.) and divide that by your gross monthly income (your total income before taxes and other deductions). More on that in following sections.
Front-End DTI Vs Back-End DTI
There are two types of DTI that lenders look at: front-end and back-end. Your front-end DTI only takes into account your housing-related expenses, such as mortgage or rent payments, property taxes, homeowners insurance, and homeowners association dues. Your back-end DTI includes all of your monthly debt payments, including your housing-related expenses.
While front-end DTI is often used to determine what home you can afford, back-end DTI is the number that lenders focus on because it gives them a more complete picture of your monthly spending.
Why DTI is Important
Lenders want to make sure that you’re financially capable of handling your mortgage payments on time each month, which is why they focus on your DTI. If you have a high DTI, you may not be approved for a mortgage, or you may only be approved for a smaller mortgage than you had hoped for.
What Counts as a Good DTI Ratio?
While most lenders prefer a DTI ratio of 43% or less, the specific requirement depends on the type of mortgage you’re applying for. FHA loans, for example, have a maximum DTI of 57% with automated approval, while USDA loans require a DTI of up to 46% in certain circumstances.
A DTI ratio of over 50% indicates that you have high levels of debt, and lenders will likely deny you a mortgage. If your DTI is between 43% and 50%, it’s likely you have a lot of debt and may struggle to get approved for a mortgage.
Ratios between 36% and 41% indicate that you have reasonable levels of debt, and lenders are more likely to approve loans for people with these DTIs. DTI ratios below 36% show lenders that you have truly reasonable levels of debt, and you shouldn’t have any trouble qualifying for new loans or lines of credit, assuming other program guidelines are met.
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Calculating Your DTI
Calculating your debt-to-income ratio doesn’t have to be difficult. Here’s a step-by-step guide on how to calculate your ratio in just a few simple steps.
1. Add Up Your Minimum Monthly Payments
Only include account balances such as student loans with minimum monthly payments when calculating your DTI. Examples of what’s typically considered debt when applying for a mortgage include:
- Rent or monthly mortgage payment
- Homeowners Association (HOA) fees
- Property tax payments
- Homeowners insurance payments
- Auto loan payments
- Student loan payments
- Child support or alimony payments
- Credit card payments
- Personal loan payments
Do NOT include non-essential expenses, such as entertainment, utility bills, transportation, or personal savings in your DTI calculation. And a good rule of thumb on student loans, if you don’t currently have a monthly payment, is to calculate a payment based on .5% of the total balance. So, if you have $30,000 in total student loan balances, most programs will calculate that monthly student loan payment at $175.
2. Calculate Your Gross Monthly Income
Gross monthly income is the total amount of pre-tax income you earn each month. If another person is applying for the loan with you, factor their income and debts into the calculation.
Once you’ve determined the total gross monthly income for everyone on the loan, divide the total of your minimum monthly payments by your gross monthly income.
3. Convert Your Result to A Percentage
After calculating the decimal number, multiply that by 100 to find the percentage. For instance, if your monthly gross income is $6,000 and the total monthly payments are $1920, divide $1920 by $6,000, resulting in .32. Finally, multiply that by 100 to obtain your 32% DTI ratio.
If your DTI ratio is below 43%, it should be easy to qualify for a mortgage. Otherwise, consider paying off high-interest debts, reducing your monthly expenses, or increasing your income to improve your DTI ratio. By following these easy steps, you can determine where you stand with lenders before you apply, so you can move forward wisely.
How to Improve Your DTI
If your DTI is high, there are several strategies you can use to lower it before you apply for a mortgage.
Paying off high-interest debts
Allocating some monthly income or savings to pay down, or off, some high-interest debt can go a long way in reducing your debt-to-income ratios and allow you to qualify for a larger loan amount, and more expensive home. Your Lender can usually analyze your debt and determine the best approach to paying down or off accounts.
Reducing your monthly expenses
This seems like the most obvious way to reduce your DTI. Reducing your outgoing monthly liabilities is often the key to qualifying for the most money, and getting the best terms for your next mortgage. This includes getting rid of non-essential bills like RV and recreation loans.
Increasing your income
This last tactic can be a great way to lower your DTI, however it does take some time. Getting another job, or side hustle can increase your monthly income to be able to qualify for more, but most loan programs will require a two year history of secondary employment. So, if you are counting on using income from a second job for qualifying, make sure you are allowing some time to get the rest of your finances in order, for the best chances at qualifying, when that income becomes eligible.
Get a Co-Signer for the loan
Most available programs allow for a co-signer to help borrowers qualify for a higher loan amount. A co-signer is typically a family member, or someone with a close relationship, that may or may not live in the home, co-signing on the loan with you. This person is also liable for repayment on the loan, but in most cases, their income can be used to help to lower your DTI.
The DTI for the co-signer is also calculated, so it is vital they have a low DTI to maximize the benefit of putting them on the loan with you.
Conclusion
Understanding your debt-to-income ratio is crucial when it comes to purchasing a home. By calculating your DTI, you can determine your eligibility for a mortgage. A high DTI ratio could prevent you from being approved for a mortgage or limit the amount of mortgage that you can borrow.
By following the strategies outlined above, you can lower your DTI and increase your chances of being approved for a mortgage.
Frequently Asked Questions about DTI
What is DTI (Debt-to-Income Ratio)?
Debt-to-income ratio (DTI) is a calculation that measures your total income against any debt that you have. It helps lenders understand your ability to manage your finances and make consistent mortgage payments.
What counts towards my Debt-to-Income Ratio?
When calculating your DTI, all your monthly debt payments ranging from credit cards, student loans, auto loans, personal loans, rent, property taxes, and homeowner insurance go into the calculation.
What is a good DTI Ratio for me to get approved for a mortgage?
Most lenders recommend that borrowers should have DTI ratios of 43% or less. Ratios between 36% and 41% tend to indicate reasonable amounts of debt, and lenders are more likely to approve loans for people with these DTIs. Meanwhile, ratios of 50% and more indicate high levels of debt, but some programs allow for approvals above that.
How can I calculate my DTI?
To calculate your DTI, add up all your monthly debt payments then divide the amount by your gross monthly income. Then multiply that number by 100 to get a percentage.
Does the type of loan I apply for affect my DTI limit?
Yes, the type of loan you apply for affects your DTI limit. For example, FHA loans have a maximum DTI limit of 57%, while USDA requires a DTI below 46%. Lenders may set their limits for other loan types, so it’s essential always to check with your lender.
What can I do if my DTI is high?
If you’re struggling with a high DTI, your first step should be to review your finances and cut back on expenses. Consider paying off some of your debts if possible, starting with your smallest balances. Make more than the minimum monthly payment, and look for ways to increase your income, such as establishing a side hustle, to lower your DTI ratio over time.
