You want to buy a home but are unsure whether a lender will approve you for a mortgage loan. Calculate your debt-to-income ratio to determine your eligibility and learn how to improve your chances of loan approval.
What Is Debt to Income Ratio
A debt-to-income ratio (or DTI ratio) is a calculation used by mortgage lenders to determine a borrower's financial health and ability to meet debt obligations, specifically the monthly mortgage payment's affordability. The ratio is calculated by comparing your total monthly debt payments (such as student loan payments, credit card payments, car payments, insurance premiums, alimony, and other monthly bills) to your monthly gross income.
When determining borrowing risk, lenders prefer a low debt-to-income ratio (usually less than 36%) combined with a high credit score and a small down payment.
What Is the Difference Between Front-End and Back-End DTI?
During the mortgage process, your lender will look at two types of debt-to-income ratios: front-end and back-end.
1. Front-end ratio: The percentage of your income that goes toward housing expenses only, such as your mortgage or rent payment, homeowners insurance, property taxes, and homeowners association (HOA) fees, is represented by your front-end DTI.
2. Back-end ratio: The percentage of your income that goes toward your total monthly debt obligations (as shown on your credit report), including housing costs, is represented by your back-end DTI. The amount of your mortgage loan plus the minimum payment on any monthly debt, such as personal loans, car loans, credit cards, child support, or student loans, is included in your back-end DTI.
Lenders consider back-end ratios to be more important than front-end ratios for home-buying loans because they include all of your debt, but they will consider both when you apply for FHA loans (government-backed mortgages).
How to Calculate DTI
You can use an online debt-to-income ratio calculator to calculate your DTI ratio, or you can calculate it by adding up your total monthly debt payments and dividing them by your total gross monthly income as follows:
1. Total your minimum monthly debt payments. Include only your debt payments, such as auto loan and credit card minimum payments. You are not required to pay more than the minimum payment amount or to include monthly bills such as food, utilities, or health insurance premiums.
2. Divide your monthly minimum debt payments by your monthly gross income. Your gross monthly income is the amount of money you make before taxes (net income) or the total gross monthly income of you and anyone else applying for the loan. Subtract your minimum monthly payments from your gross monthly income.
3. Multiply by 100. Multiply the resulting number by 100 to get the percentage. For instance, if your monthly gross income is $4,000 and your monthly debt payments are $1,000, divide $1,000 by $4,000 to get.25, then multiply by 100 to get a DTI ratio of 25%.
What Is a Good DTI?
Though lenders differ, and you may be able to qualify for a new loan with a higher DTI, most financial institutions consider a back-end DTI ratio of 36 percent or lower to be a good DTI ratio, and they avoid lending to anyone with a DTI of more than 50 percent. Because a higher credit score and lower DTI ratio help you secure a better mortgage interest rate (which means paying less in the long run), it is in your best interest to pay off your debts as soon as possible.
You may be able to qualify for a government-backed FHA loan or refinance using your current home equity even if you have a higher DTI (up to 57 percent) and a lower credit score.
5 Mortgage DTI Reduction Strategies
Consider the following strategies to reduce your high DTI ratio and make you a more appealing mortgage loan candidate:
1. Add a new borrower to the loan. Adding a person to your loan raises your household's gross monthly income and lowers your DTI ratio automatically.
2. Avoid incurring additional debt. If you intend to apply for a home loan soon, avoid incurring new debt, which will result in a higher DTI ratio.
3. Increase your earnings. To reduce your DTI, increase your gross monthly income with a higher-paying job or additional work for at least two years.
4. Pay off your existing debts. Eliminating even one of your monthly debts, such as your auto loan, will improve your ratio and qualify you for a better mortgage rate. The lower your DTI ratio, the less debt you have.
5. Consolidate your debt. Refinancing existing debt to lower monthly payments lowers your DTI ratio and increases your chances of qualifying for a home loan.