When applying for a mortgage, debt-to-income ratio (DTI) is one of the factors, along with credit score and income, that lenders use to determine your mortgage eligibility.
If you’re hoping to qualify for a mortgage or a refinance, you’ll need to know about your debt-to-income ratio and take steps, if needed, to improve it.
We’re here to help by telling you everything you need to know about your DTI.
What Is Debt-To-Income Ratio?
DTI is the percentage of your gross monthly income that’s spent on monthly debt payments. These payments include credit cards, student loans, car loans, child support and mortgage payments. Your DTI, like your credit score, helps lenders determine how much of a credit risk you present.
If you’re worried that your DTI might be too high to qualify for a loan, don’t worry. It’s possible to improve your debt-to-income ratio. We’ll talk more about that later.
How To Calculate Your Debt-To-Income Ratio
Your debt-to-income ratio compares how much money you owe per month to how much money you earn per month. Figuring out your debt-to-income ratio is not as difficult as it may seem. Use the information below to calculate what your DTI is.
Step 1: Add Up Your Fixed Monthly Debts
These expenses may include:
- Monthly rent or house payment
- Minimum monthly credit card payments
- Student, auto and other monthly loan payments
- Monthly alimony or child support payments
- Other debt
Some other payments, like groceries, utilities, gas and taxes are typically not included in the DTI calculation, but remember to take them into account as you plan your future homeownership budget. Expenses like electricity, property tax and transportation may increase when you move.
Step 2: Divide By Your Gross Income (Income Before Taxes)
Sources of income can include:
- Business profits
- Tips and bonuses
- Social Security
- Child support and alimony
Step 3: Convert Your Answer To A Percentage
The final result is your debt-to-income ratio.
Let’s work through an example. Assume you pay rent at a monthly rate of $1,000, a car payment of $400 and a minimum credit card payment of $150. Let’s also assume that you have a gross monthly income of $5,000. Your debt-to-income ratio is $1,550 divided by $5,000, which equals .31 (or 31%). Lenders consider those with a lower DTI to present a lower credit risk. Not only will you more likely be preapproved, you’ll also likely qualify for a lower interest rate. The lower your DTI, the less credit risk you are to lenders.
Why Your DTI Is So Important
Your DTI is important because it helps lenders determine your mortgage eligibility and the likelihood you will repay a loan.
Just like your credit score, your DTI significantly affects your financial health and possibilities for qualifying for a mortgage or taking on more debt. For example, if you were applying for a store credit card and had a DTI of 60%, your credit card interest rates would be high because your DTI is considered high. If your DTI had been 40%, your interest rates would have been in the middle, and if you had had a low DTI of 15%, your interest rates would be low.
Typically, a good debt-to-income ratio is 35% or less. You can still qualify for a loan with a DTI ranging from 36% to 49%, but if your DTI is 50% or greater, you should take action to improve it before applying for a mortgage.
Debt-To-Income Ratio For A Mortgage
Generally, in order to qualify for the most mortgage loan options, you should have a debt-to-income ratio no greater than 43%. However, it’s important to note that mortgage qualification is based on a variety of factors including loan type, down payment, housing expense ratio and credit score.
If you’re looking to get a mortgage, DTI is just one of the new terms you’ll hear. Make sure you understand all the important terms related to your mortgage process, and know which questions you should ask your mortgage lender.
How To Improve Your Debt-To-Income Ratio
If you want to improve your DTI and increase the chance of getting a better interest rate, here are some ideas that may help.
Figure Out Where You Spend Your Money
Track your spending for a week or two, and you’ll be astonished at the ways your money disappears. In addition to simply making you more mindful of your spending, expense tracking will help you identify all the splurges that accumulate too much outflow. Identify some places where you can cut back (be realistic!), and you’ll be surprised how much your spending adds up.
Make A Plan To Reduce Your Debt
Once you’ve identified those savings, make a plan to reduce your debt. There are a variety of popular approaches to this, and two of the most popular trends involve snowballs and avalanches. The snowball method suggests paying off your smallest debt first and working your way up to your largest. The avalanche method posits that it is better to tackle your highest-interest debt first. Either way, the result is the same. Your debt gets paid off more quickly, and you save money and lower your DTI.
Find Ways To Make Your Debt Less Expensive
If you’re carrying high-interest credit card debt, try to find less costly debt alternatives. You can start by asking your current debtors for a lower interest rate. If you already own a home, you might consider a home equity loan to consolidate debt. You might consider applying for a personal loan with a fixed repayment schedule. In some cases (but read below!), it might make sense to get a low interest rate credit card and transfer your balances before you cut up the original cards!
Another similar strategy is to reduce your credit card charges or ditch your card altogether. Fewer expenses on your credit account will cut payments that you have to make in the future. Go old-school and try to use cash for expenses like food and clothes. Limiting your spending to cash purchases can also help you save money on daily purchases to put toward paying off debt. This strategy is interest-free and can help you increase your mindfulness around your spending habits.
Avoid Adding New Debt
While you’re paying down your current debt, don’t take on any new debt. Even if you don’t use a new credit card, the fact that you have one that you could use will be a red flag to lenders.
Let’s consider this example. You’re shopping responsibly for some necessities and you’ve got cash in hand. You get to the register and the helpful cashier tells you that you could save 25% of your total bill if you apply for a store credit card. You say that you’d rather pay in cash, but you’re thinking to yourself that if you saved that 25%, you could splurge on lunch, guilt-free. The cashier informs you that you can apply for the credit card, get 25% off and pay in cash. A few seconds later, the deal is done, and you’re heading off to a better meal than you planned.
Here’s the catch. In the eyes of prospective lenders, you’ve now increased your potential debt. Doing this once might only ding you slightly. But do it a few times and you’ve created a bigger problem for yourself. Remember: There’s no such thing as a free lunch!
On the other hand, if you can qualify for a credit card with an extremely low (or even 0%) introductory rate, it might be worth getting one and transferring your higher interest balances to it. This way, you’ll avoid any additional interest charges as you pay down the balance. To make this work, from a DTI standpoint, you should formally close your other credit accounts and stick to your payoff plan.
Your reward comes when you apply for a mortgage. Your lower DTI will help you qualify for lower interest rates and better loan terms.
To recap, your debt-to-income ratio (DTI) is the percentage of your gross monthly income that is spent on monthly debt payments. It’s important, because lenders use it to determine if you’re a good credit risk, and to qualify you for the best interest rates and terms to reach your homeownership goals.