Understanding Debt-to-Income Ratio
- posted 10.31.2019
- Taylir Paynter
- Personal Finance
In addition to your credit score, your debt-to-income (DTI) ratio plays a crucial part of your overall financial health when you apply for a mortgage. It’s actually one of the most important aspects mortgage lenders use to assess your credit worthiness. It measures the size of your monthly debt obligation relative to the amount of your monthly pay. DTI also helps lenders determine whether you’re capable of taking on a loan.
If you’re interested in buying a house, read along and discover what exactly a DTI is and what the ideal DTI ratio would be for a mortgage.
What factors make up a debt-to-income ratio? There are two types of DTI ratios that Mortgage lenders use: front-end DTI and back-end DTI.
A front-end ratio uses your monthly gross income to determine what percentage of that would go toward your housing costs, including your monthly mortgage payment, property taxes, homeowner’s insurance, mortgage insurance, and homeowner’s association fees.
A back-end ratio shows what extent of your income is needed to cover all of your monthly debt liabilities combined. It includes any credit card debt, car payments, child support, student loans, monthly mortgage payment and other debt amounts that may show on your credit report.
Calculating your debt-to-income ratio: To determine your back-end DTI ratio, you’ll want to add up all of your total recurring monthly debt payments, such as student loans, car payments, child support, credit card payments, etc. and divide that number by your gross monthly income. For those who aren’t sure what your gross monthly income, it’s the amount that you earn each month before taxes and other deductions are taken out of your paycheck.
It's also imperative to note that your DTI ratio doesn’t acknowledge the amount of money you’re using to pay for living expenses that are not on your credit report such as car insurance, cost of groceries, and any entertainment expenses you may have.
What is the ideal debt-to-income ratio? Lenders typically say the ideal DTI ratio should be no more than 28 percent for the front-end ratio and for the back-end ratio, it should be 36 percent or lower. Keep in mind, depending on what your credit score is, how much savings you have, and the amount of down payment you’re gong to provide, lenders may accept higher ratios, depending on what type of loan you’re trying to apply for.
A low DTI ratio indicates a good balance between debt and income. In general, the lower the percentage is, the better the chance you will be able to get the loan that you want. If your DTI ratio is on the higher side, you may have too much debt for the amount of income you have.
Of course, the lower your DTI is, the better terms you may get approved for and the better chance you may have at qualifying for a lower mortgage rate. You can use our home affordability calculator to help estimate how much house you can afford based on your income and monthly expenses.
How can you lower your debt-to-income ratio? There are two ways to lower your DTI ratio. One is to reduce your monthly recurring debt by paying off debt and includes not taking on any more debt than what you already have. Another way to lower your DTI ratio is to increase your gross monthly income. To do this, you could find a second job or work as a freelancer when you have extra time. You can also try and pick up more hours at your current job if you don’t want the hassle of a second job.
If you’re interested in obtaining a mortgage, remember your Loan Officer is a great resource to help you with any questions that you may have.
Give us a call today. We’re here to help you every step of the way through your loan process.