Thinking about buying a home and getting a mortgage? Then you need a crash course in debt-to-income ratio (DTI).
While your credit score may get your foot in the door, lenders use your DTI to decide if you’ll be able to afford your monthly mortgage payments. Knowing this powerful percentage can help you get a mortgage.
What is Debt-To-Income Ratio?
Your DTI takes your current debt and measures it as a percentage of your income.
That percentage tells lenders how much income you have left over each month after you pay your bills.
For example, you may have a modest income, but you only have a few tiny monthly bills. Or maybe you make six figures, but over half your monthly income goes to making the minimum monthly payment on your credit cards.
IRL, it may look like this: rapper Kanye West once earned $72 million but claimed to be $53 million in debt. His finances are complex, but if a lender used just those numbers, he’d have a DTI of 74%. With a DTI that high, most lenders wouldn’t approve Yeezy for a mortgage.
That’s what DTI does: It provides a view of your finances that your income and your credit score can’t measure.
How Do You Calculate Your DTI?
Generally, here’s how you figure out your DTI.
Debt-to-income ratio = Your total monthly debt divided by your monthly gross income
Here’s a closer look at the factors you’ll use in a DTI equation:
Your gross monthly income is your annual salary before taxes and paycheck deductions divided by 12.
Your total monthly debt is the total of all the payments you HAVE to make each month, including:
- Rent, mortgage and other housing-related expenses, like utilities
- Credit card payments and personal loan payments
- Student loan payments
- Car loans
- Alimony/child support payments
To calculate your DTI, add up your debts, determine your income and then plug them into a DTI calculator.
FYI, depending on your lender and the type of mortgage, there may be slightly different factors used for your DTI calculation. Ask your lender how they’ll calculate your DTI when you reach out about getting preapproved for a mortgage.
In the meantime, this equation gives you a good idea of how lenders will view your debt in relation to your income.
What Is a Good DTI Ratio?
The lower your DTI, the likelier it is that lenders will consider giving you a mortgage.
If you can demonstrate that you’re a sure bet, lenders will be eager to offer you a competitive interest rate and may be more open to negotiating on your mortgage terms.
The higher your DTI, the more cautious lenders will be about offering you a mortgage. And this could mean a less favorable interest rate on the loan.
What Else? Lenders look at Front-End and Back-End DTI. 👀
Lenders break down DTI into two different types: front-end and back-end.
The key difference is which monthly expenses the lender is looking at when they try to figure out your DTI.
The front-end ratio
This includes all of your housing-related expenses. Your lender wants to know that you aren’t trying to buy more home than you can afford. They’ll want to look at expenses like mortgage payments, property taxes and insurance as a percentage of income.
Recommended front-end DTI: 28% of gross income
The back-end ratio
This includes student loans, car loans and credit card debt. Lenders consider these debts along with your housing debts, combining them to create the back-end ratio. They also look at your income history.
Recommended back-end DTI: 36% of gross income
Though there has been some loosening of the regulations by Fannie Mae and Freddie Mac to allow lenders to consider DTIs as high as 50%, most lenders prefer lower DTIs. If they offer you a loan with a higher DTI, it may come with a higher interest rate and other expensive conditions.
What’s the Difference Between a Credit Score and DTI?
Unlike DTI, a credit score doesn’t take income into account. It measures the amount of money you can borrow versus the amount you owe.
For lenders, a good credit score is a sign that you’re worth taking a risk on.
Think of it this way: if you were looking for love instead of a mortgage, your dating profile would be your credit score.
When lenders land on your credit score, they can decide to swipe left or swipe right.
But once you’ve matched, the real scrutiny begins.
In the same way, lenders use DTI to measure the real you (from a financial POV) to decide your mortgage worthiness.
Get the Down Low On Your DTI
Before you look for a mortgage, it’s a good idea to take a look at all of your debts and ask:
- What percentage of income do your debts represent?
- Will student loan debt affect your ability to buy a home?
- How much home can you really afford?
What If You Have a High DTI? Empower Your Percentage!
The smaller the DTI percentage, the mightier!
If you’re concerned about your current DTI, you may need to lower your percentage before you start applying for mortgages.
You have two options:
First, try lowering your debt by:
- Cutting expenses and devoting more income toward paying down debt
- Aggressively paying off high-interest debt
- Refinancing or consolidating debts to lower interest rates
- Looking for student loan refinancing or income-driven repayment plans
The second way is to increase your income.
Depending on your situation, try asking your boss for a raise or look into starting a side hustle.
Even if your DTI is high, all is not lost. You may still qualify for some types of loans, like an FHA or VA loan. These loans are less risky for lenders because of their partial government backing.
Why Keeping Your DTI Low Is Smart
Keeping your DTI under control is a smart financial move. It doesn’t mean you can’t live the good life, just be sure to keep your debt from getting out of control. Low monthly debt means more income left over to save, occasionally splurge and – most importantly – invest for the future.
Keep track of your income and expenses and check your DTI every month. With a little effort, you can bring your DTI below that magic 36% mark.