One’s debt-to-income (or DTI) ratio is a comparison between how much a person pays each month in debt, versus how much they earn. This figure is incredibly important to mortgage lenders, as they don’t want to loan such large sums to those who live “too close to the edge.” Even if you make your monthly debt payments on time, practice healthy credit behaviors and have a good credit score, your DTI could impact your ability to get a mortgage loan. The mortgage lenders need to feel confident that you can repay your mortgage loan, in addition to what you already pay per month toward other debts.
Truthfully, your DTI is just as important as your credit score. Continue reading to learn what constitutes a healthy DTI, as well as how to calculate this figure for yourself.
Calculating Your Debt-to-Income Ratio
There are two forms of DTI that need to be calculated:
- Front-end ratio: This figure determines what percentage of your income would go toward the expenses of owning a house. This includes the cost of your monthly mortgage payment, homeowner’s insurance, association dues and real estate taxes.
- Back-end ratio: The back-end ratio relates to other monthly payments that you make. This includes credit card payments, child support, and literally any other monthly bill or debt you pay.
Calculating Your Front-End Ratio
To determine your front-end ratio, add up your expected household costs and then divide that number by your gross monthly income. Multiply that new number by 100 and the result is your ratio.
Calculating Your Back-End Ratio
Add your monthly payments and expenses to the front-end figure and then divide that number by your gross monthly income.
What is a Healthy Debt-to-Income Ratio?
As we stated above, lenders want to work with clients who have a good debt-to-income ratio. But what constitutes “good” in this scenario?
An ideal front-end ratio is 28% or less. The back-end ratio should be no more than 36%, after factoring in all expenses. DTI ratios higher than these two figures can significantly stand in the way of you getting the loan that will put you into your new home.
How to Improve your DTI Ratio
There are only two ways to improve your debt-to-income ratio: pay off some of your debts or earn a higher income. If neither of these options are possible for you at this time and your DTI ratios exceed the recommended percentage, it might not be wise to attempt to move forward.
Some lenders will work with very high DTI ratios, but that doesn’t mean that you should dive in and get that loan. It’s not worth it to run oneself too close to the limit of their finances with more debt that can be reasonably managed. If your DTI ratios are excessive, take some time to tackle your debts and perhaps even increase your income before you seriously apply for a mortgage loan.