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 at what interest rate? Here’s a look at what debt-to-income measures and why it’s so important.
What Is Your Debt-To-Income Ratio?
Your debt-to-income ratio, or DTI, measures how much of your gross monthly income is eaten up by your monthly debts.
Lenders will look at your front-end debt-to-income ratio, which measures how much is used for your monthly mortgage payment, including property taxes, mortgage insurance and homeowners insurance payments.
In addition, you’ll also have a back-end DTI ratio. Back-end DTI measures how much of your gross monthly income you spend on all of your expected expenses such as your mortgage or rent, any credit card minimum payments, auto loan payments, student loan payments and other forms of debt.
Different lenders will consider different ratios. When you apply for a mortgage loan, though, your lender will typically look at all your recurring monthly debts, including your estimated new mortgage payment, when calculating your debt-to-income ratio.
To calculate your debt-to-income ratio (DTI), you’ll take how much money you owe each month and divide it by how much you earn, before taxes.
Why Is Your DTI Important?
Lenders want to make sure borrowers can comfortably afford their monthly payments once they get a new mortgage. DTI is one of the tools that lenders use to help clients find an affordable payment that won’t create financial troubles in the future.
How To Calculate Your Debt-To-Income Ratio
To determine your debt-to-income ratio, divide your monthly recurring debts – such as your rent or current mortgage payment, auto and student loan payments and the minimum you must pay each month on your credit card debt – by your gross monthly income.
Let’s assume your gross monthly income – which is your income before taxes are taken out – is $6,000. And, your total monthly debts are $2,000. If you divide $2,000 by $6,000, you come up with about 0.33. That comes out to a DTI ratio of 33%, meaning that your monthly debts consume 33% of your gross monthly income.
In another example, your gross monthly income is $7,000 and your monthly debts are $3,000. That comes out to a higher debt-to-income ratio of about 43%.
Here’s how a high DTI ratio can hurt you: Say you have a strong FICO® credit score of 780. You might also have a solid employment history and enough money saved to cover not only your down payment, but 2 months of mortgage payments.
You should be an ideal borrower, right? Maybe. But what if you also have thousands of dollars of credit card debt, are financing an expensive car and are saddled with student loans? These expenses might leave you with a debt-to-income ratio so high that the addition of a monthly mortgage payment will be too much of a financial burden.
If your debt-to-income ratio is too high, your lender may not be able to approve your application for a mortgage.
What Should Your Debt-To-Income Ratio Be For A Mortgage?
What is a good debt-to-income ratio? What ratio should you aim for? That varies by lender and loan type, but many mortgage options require your total monthly debts, including your new mortgage payment, to equal no more than 43% of your gross monthly income.
This doesn’t mean that you can’t qualify for a mortgage with a debt-to-income ratio higher than that. A very high DTI may require you have a slightly higher interest rate to make up for the increased risk created by the high DTI.
Tips To Improve Your DTI
Fortunately, you can lower your debt-to-income ratio. It’s all about paying off your debt and boosting your gross monthly income.
Here are some steps to take to lower a DTI that’s too high.
- Avoid taking on more debt: The more debt you take on, the higher your debt-to-income ratio will grow. If you are already burdened with a high amount of debt, don’t add to it by taking out an auto loan or personal loan. And don’t run up more credit card debt. It’s especially important to avoid new debt when applying for a mortgage. Your lender will look carefully at your debt burden and won’t approve your loan request if your DTI is too high.
- Increase your income with a side hustle: Another way to improve your debt-to-income ratio is to increase your income. You might be able to do this with a second job, such as driving for a ride-sharing service, delivering food or cleaning homes. There is a challenge here, though: Lenders want to make sure that your part-time income is steady and reliable. To prove this, you typically may have to show that you’ve been working at your side job for at least 2 years. This can vary though, so check with your lender.
- Increase how much you pay on your debt: Create a household budget listing your income coming in and your expenses going out. This will help you determine how much money you can devote each month to paying down your debt. The more dollars you can devote to paying off debt each month, the lower your debt-to-income ratio will fall. If you can spare $100, $200 or more each month on paying down your auto loan balance or credit card debt, you can slowly but steadily improve your debt-to-income ratio.
- Get a higher-paying job: This isn’t an easy fix, but if you land a job paying you a higher income, your debt-to-income ratio will improve. If you are interested in landing a new job, you might consider starting your search before you apply for a mortgage.
Need help tracking your spending and debts? Sign up for our Rocket MoneySM app that will give you the tools necessary to improve your debt-to-income ratio.
The Bottom Line: Know Your DTI Before Applying For A Mortgage
It’s important to know your debt-to-income ratio before applying for a mortgage. You can then take any steps necessary to lower your debt or boost your income before applying with a lender.
If you are ready to improve your finances and take the first steps in buying a home, you can get started by talking to one of our Home Loan Experts today.