Debt-To-Income Ratio (DTI): Everything You Need To Know
You probably know that your three-digit credit score is an important number when you’re applying for a mortgage. But did you know that your debt-to-income ratio plays a key role, too, in determining whether you qualify for a mortgage and what interest rate you’ll pay?
Here’s a look at what DTI ratio measures – and why it’s so important.
Key Takeaways:
- Your DTI ratio is a figure that compares the amount of debt you owe to your gross monthly income.
- Lenders use your DTI ratio to evaluate whether you’ll be able to afford your mortgage each month.
- To improve your chances of getting approved for a mortgage, it’s best to aim for a DTI ratio of 36% or less.
What Is A Debt-To-Income Ratio?
Your debt-to-income ratio, or DTI ratio, measures how much of your gross monthly income is eaten up by your monthly debts.
Lenders want to make sure borrowers can comfortably afford their monthly payments once they get a new mortgage. That’s why they use your DTI ratio to measure your ability to repay the money you want to borrow.
If you earn a decent income but are saddled with debt, lenders might predict you’ll run into trouble making your mortgage payments every month. As a result, it could be harder to qualify for a mortgage. On the other hand, if you have little debt, you pose less risk as a borrower. This should make qualifying for a mortgage easier.
What Should Your DTI Ratio Be For A Mortgage?
What is a good DTI ratio? That varies by lender and loan type, but a DTI ratio of 36% or less is generally considered safe.
This doesn’t mean it’s impossible to qualify for a mortgage if your DTI ratio is more than 36%. However, a high DTI ratio may mean you’ll pay a higher interest rate to make up for the increased risk to your lender.
Here are some common DTI ratio ranges and how they can affect your chances of getting a mortgage:
- DTI ratio of 35% or less. This shows lenders that you likely have a reasonable amount of money left over after paying your debts, and you don’t pose much risk as a borrower. As a result, you shouldn’t have a hard time qualifying for a mortgage.
- DTI ratio of 36% to 41%. This signals to lenders that you have a manageable amount of debt and sufficient income to cover it. However, if you want to take out a larger loan or your lender is strict, you may be asked to lower your DTI ratio first or meet additional qualifications.
- DTI ratio of 42% to 49%. This suggests you might have trouble keeping up with your mortgage payments. You may need to meet additional requirements to get approved.
- DTI ratio of 50% or more. This indicates you probably won’t be able to afford your mortgage payments each month. As a result, your loan application will likely be denied.
Front-End Vs. Back-End DTI Ratio
There are two different types of DTI ratios that lenders may look at.
First is the front-end DTI ratio, which measures how much of your gross monthly income will be used on your monthly mortgage payment, including property taxes, mortgage insurance and homeowners insurance. Lenders usually limit your front-end DTI ratio to 28% or less.
The more important figure is your back-end DTI ratio, which measures how much of your gross monthly income you’ll spend on your housing expenses and long-term debts, such as credit card payment minimums, auto loan payments and student loan payments. This gives lenders a more complete view of your finances.
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How To Calculate Debt-To-Income Ratio
The formula for calculating your DTI ratio is:
(Total Monthly Debt / Gross Monthly Income) × 100 = DTI Ratio
Here’s a step-by-step guide to using the DTI formula to determine your debt-to-income ratio.
1. Determine Your Minimum Monthly Debt Payments
Calculate how much you owe by adding up all your monthly debt payments. You only need to count the minimum amount you owe every month for each debt, not the account balance.
The following types of debt count toward your DTI ratio:
- Future mortgage (including principal, interest, taxes and insurance)
- Homeowners association fees
- Credit card debt
- Auto loans
- Student loans
- Personal loans
- Alimony
- Child support
The following types of debt don’t count toward your DTI ratio and should be excluded:
- Health insurance premiums
- Home utilities
- Transportation costs
- Savings account contributions
- Retirement account contributions
- Groceries, clothing and entertainment costs
2. Divide By Gross Monthly Income
Your gross monthly income is the amount of money you earn each month before taxes and other deductions are taken out. These deductions can include health insurance premiums and retirement savings.
Take your total monthly debt payments and divide them by your gross monthly income.
3. Convert Into A Percentage
Once you’ve divided your debt payments by your gross income, the result will be a decimal amount. The last step is to convert this figure to a percentage by multiplying it by 100. So, if the result was 0.40, then your DTI ratio is 40%.
DTI Example
Let’s assume your gross monthly income is $6,000. Then you take a look at your monthly debt obligations:
- Rent: $1,000
- Credit card payment: $500
- Auto loan payment: $500
Add that up, and your total monthly debts are $2,000. If you divide $2,000 by $6,000, you come up with about 0.33. That means your DTI ratio is 33%, and your monthly debts consume 33% of your gross monthly income.
On the other hand, say your gross monthly income is $7,000 and your monthly debts are $3,000. That comes out to a higher DTI ratio of about 43%.
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Tips To Improve Your DTI Ratio
Fortunately, you can lower your debt-to-income ratio. It’s all about paying down your debts and boosting your gross monthly income.
Here are some steps to take to lower a DTI ratio that’s too high:
- Increase how much you pay on your debts. The more money you can devote to paying off debt each month – ideally more than the minimum monthly payments – the lower your DTI ratio will fall. If you can spare $100, $200 or more each month to further pay down your auto loan balance or credit card debt, then you’ll slowly but steadily improve your DTI ratio.
- Avoid taking on more debt. The more debt you take on, the higher your DTI ratio will grow. If you’re already burdened with debt, don’t add to it by taking out additional loans or running up more credit card debt. It’s especially important to avoid new debt when applying for a mortgage.
- Increase your income. You can do this by asking for a raise, freelancing, or starting a second job, such as driving for a ride-sharing service or delivering food. There’s a challenge here, though: Lenders want to make sure that your part-time income is reliable. To prove this, you may have to show that you’ve been working at your side job for at least two years.
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FAQ
Here are answers to some frequently asked questions about DTI ratios.
The Bottom Line
Your debt-to-income ratio can have a big impact on whether you’re approved for a mortgage and the interest rate you’ll be offered. Before you apply for a mortgage, calculate your DTI ratio on your own to see where you stand. If it seems high, you can then take steps to lower it before contacting a lender.
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Rory Arnold contributed to the reporting of this article.
