Debt-to-income ratio, or DTI ratio, is used by lenders to calculate how much of a mortgage payment they can justify giving you. You will want your DTI to be on the lower end in order to qualify for a larger mortgage. This article will cover how to calculate your DTI ratio, and the ideal ratio in order to qualify for a loan.
How Is It Calculated?
Your DTI ratio will be calculated based on your gross income each month and your total monthly debts. Your monthly debts include student loans, car loans, credit card debt, and other liabilities that you must pay on each month.
Here’s an example:
- You and your spouse earn $10,000/month in gross income.
- You and your spouse have a combined monthly liability of $3,500.
- Your debt-to-income ratio is 35%.
Now, as you reach a higher level of income, lenders typically accept a higher debt-to-income ratio, but it all breaks down to many factors that go beyond debts and income. Factors considered by lenders include assets, job stability, co-signers, etc. Lenders will each set their own standards to decide if you are eligible for the loan you are requesting or not.
What’s The Right Ratio?
There is no one set rule as to how large of a debt-to-income ratio you can have and still get a loan if you are opting for a conventional mortgage, which is a mortgage in which you are going directly to a private lender with no government agency (such as the FHA) insuring or guaranteeing your loan. With a conventional mortgage, it is entirely up to your lender to determine if your debt-to-income ratio is acceptable or not.
Typically, however, the ideal debt-to-income ratio is considered to be around 30% or below (with below being better). You can be approved with a debt-to-income ratio of 40% or 50%. Being approved with a debt-to-income ratio higher than 50% is considered extremely unlikely, even with perfect credit. Lenders will look at your situation and consider you to be too much of a liability.
Front-End Ratio & Back-End Ratio
If, out of your $3,500 monthly liabilities, your mortgage payment will make up $2,000 of your debt, you will have a front-end DTI ratio of 20%. Your front-end ratio includes your principal, interest, taxes, and mortgage insurance premiums.
Your back-end DTI ratio in this scenario would be 35%, which is the number that includes all of your debts and liabilities such as student loans and credit card debts. The back-end DTI ratio is considered more important, but lenders will have requirements for both.
How Do I Decrease My DTI?
You can bring down your debt-to-income ratio and help raise your chances of being accepted for a loan by paying off some of your debts. You can do this by paying down loans and credit card debt or by selling one of your debts, such as a secondary car or another item you are in the process of paying off.
However, before you begin breaking down your debts, it is important you realize that not all debts are seen as equal in the eyes of lenders. High-interest debt is considered the worst, which means you can consider refinancing a high-interest student loan or car loan, or refinancing a credit card debt that is subject to high interest. In fact, while you are reviewing your credit situation, credit card debt is a good place to focus. Consider consolidating your debt into one card and enjoy no/ low-interest entry rates by transferring your credit card balance to a new card.
Before you begin searching for a new credit card or refinancing a loan, there are a couple other final considerations to make. First, keep in mind that your credit report will be pulled each time you submit a request for a new credit card or a refinancing application. This shows up as a “hard pull” on your credit report, and lenders typically do not want to see pulls on your report within the 6-12 months leading up to your mortgage application. This is because a high number of inquiries on your report raises a red flag, showing that you are looking for a line of credit which could make them feel that you are struggling with your current income ratio.
However, this might still be the right option for you. In this instance, though, you will want to go to a mortgage lender directly, in-person, so that you can discuss these aspects and explain your viewpoint.
Now, if you are seeking a non-conventional loan, such as one backed by the FHA or VA, you will want to precisely calculate your debt-to-income ratio as these entities impose certain requirements and limits on how much debt you can have.
The rule of thumb is usually 28/36, in which your “front-end ratio” does not exceed 28% and your “back-end ratio” does not exceed 36%.
What If My DTI Qualifies?
Having a qualifying DTI is a fantastic step forward in the process of acquiring a mortgage, however, that does not mean it's a done deal. Your lender will also look at these additional factors:
- What is the home worth? Where is it located? How much is the proposed loan amount going to be?
- How much are you putting down towards the home? Do you have a co-signer?
- What is your credit score and, more importantly, what is your credit history? Are you fairly new to credit or do you have a broad and varied history of credit cards and installment loans?
- Do you have a stable payment history? Have you owned a home before?
Obviously, having a broader credit history will work in your benefit. You are likely to have better chances by having an open car loan than by having no loan history at all. While credit cards are a great start for building credit, before a lender fronts hundreds of thousands of dollars on your behalf, they would like to see that you have history with a loan before and that you paid it off successfully, or that you’re in the process of doing so.
Once you calculate your DTI, you will have a much better picture of what sort of home loan you can qualify for. It will also let you know if you need to begin working towards lowering your DTI, which can be done through refinancing current loans at a lower interest rate or taking care of high-interest debts, like credit cards, by paying down balances or consolidating your balance and interest by transferring balances to a new card.
However, even with the ideal debt-to-income ratio, you will want to look at your credit file and make sure it’s not thin. If it is, you might have more luck applying for a mortgage after you have successfully acquired a smaller installment loan, which could mean postponing the home buying process until you are able to be qualified for a car loan or another line of credit that is larger and more substantial than a typical credit card. Once you get one of these loans and begin paying on it, lenders will be more confident in your ability to pay back your debts on a consistent basis.
While putting off your home buying process might not sound like the ideal move, it can help you score a lower interest rate, and avoid wasted inquiries (dings) on your credit report caused by mortgage lenders turning you down for lacking a thick credit history.
Either way, it is best to start the process now since buying a home is a rather complicated task. You should start by doing your homework and figuring out the right price range for your current income. You should then calculate your DTI, both your front-end and back-end ratios, and start comparing that information to the typical requirements of lenders. With that information in hand, you can finally begin the exciting process of looking for a home in your area, finding a lender, and ultimately, getting financed for your home.