How to calculate debt-to-income ratio?
Forget first dates and job interviews — nothing is more nerve-wracking than applying for a mortgage. Lenders weigh a lot of factors when deciding how big of a home loan they’re willing to extend, and that can sometimes make it feel like your entire life is being placed underneath a microscope.
Your debt-to-income (DTI) ratio is one of the most important elements that mortgage lenders will look at, so you should be sure it can stand up to scrutiny. Knowing your DTI will also help you figure out how much you can afford on a new home when you start your house hunt.
Let’s take a look at what DTI is and how it might impact your prospects of securing a home loan.
What is debt-to-income ratio?
It’s pretty straightforward, really. Your DTI ratio is the percentage of your monthly gross income that you spend paying down recurring debt. Quicker reminder: Gross income refers to the money you make before deducting funds for expenditures like healthcare premiums, 401(k) deposits, income taxes and Social Security withholding. Net income, on the other hand, is the amount of money you have leftover after taking out those items.
DTI is sometimes split into two categories: front-end DTI and back-end DTI. What’s the difference?
- Front-end DTI covers housing costs alone: mortgage, homeowners insurance, property taxes, etc.
- Back-end DTI includes all other monthly debt obligations such as car loans, outstanding credit card balances and student loans.
Looking at DTI through this lens can be beneficial if you want to isolate different types of debt and figure out how much your budget allows for housing costs. In either case, the more money you spend paying back your debt each month, the higher your DTI will be.
Why is DTI important for homebuyers?
Your debt-to-income ratio is a key element to the mortgage process, as lenders will review your DTI when deciding if they want to extend you a home loan. They’ll also take into account your DTI to determine how much money they’re willing to loan you and what interest rate to apply.
Banks and other mortgage lenders are, by their nature, risk-averse. So, they’re going to have some reservations about loaning money to a borrower who’s already struggling with debt. You may still be able to secure a home loan with a high DTI, but don’t expect to take advantage of the best current mortgage rates if that’s the case.
A lower DTI tells lenders you’re fiscally responsible, have room to take on more debt and are more likely to stay on top of your monthly mortgage payments. As such, a DTI can be a great indicator of what kind of mortgage you can get and, by extension, how much you can afford when buying a house.
How to calculate your DTI
As we said, DTI is a relatively simple concept. You don’t necessarily need a full-blown debt-to-income ratio calculator to figure it out. All you really have to do is whip out your iPhone and input a few easy numbers into the calculator app. Here’s a simple three-step process you can follow to find your debt-to-income ratio:
- Add up all of your monthly debt payments.
- Divide that number by your gross monthly income.
- Multiply the result by 100 to get your DTI percentage.
That’s all there is to it! Let’s see how that might look for someone who makes $4000 a month in gross income:
- Car payment ($400) + rent ($1,000) + Student loans ($150) + Outstanding credit card balance ($200) = $1,750 in total debt payments
- Total debt payment ($1,750)/gross monthly income ($4,000) = 0.4375
- 100 x 0.4375 = 43.75%
What is a good debt-to-income ratio?
That’s the million-dollar question, isn’t it? Generally speaking, 43% is viewed as the upper limit of what lenders will accept for a conventional mortgage. That, unfortunately, would put the person in our example above on the wrong side of the DTI threshold. Ideally, that individual would work to lower their monthly debt payments — or increase their income — to bring their DTI down.
But 43% is not a set number to aim for in every situation. Even having a DTI below that percentage won’t guarantee you a home loan, much less a favorable mortgage rate. In truth, the idea of a good DTI exists on a spectrum, depending on the type of home loan you’re applying for and the specific terms you’re hoping to secure.
- Conventional 15- or 30-year fixed rate mortgages: less than 43%
- FHA home loans: less than 50%
- VA home loans: less than 41% is preferred, but up to 65% may be OK
But you don’t want your debt-to-income ratio to just squeak by those requirements, right? Every homebuyer should strive to lower their DTI so they can not just secure a home loan, but get a low interest rate that will reduce housing costs over the length of the loan. To do that, you should aim for a DTI under 36%, in concert with a high credit score, typically over 740.
5 tips for lowering your DTI
Keeping your DTI at a level that’s appealing to mortgage lenders can feel like a tall order, but here are five ways to potentially lower your debt-to-income ratio:
- Increase your income
- Consider cheaper alternatives to monthly debt
- Stick to a budget
- Cut back on credit card purchases
- Focus on paying down debt
1. Increase your income
Obvious? Yes, but absent all other options to reduce your debt, increasing your income is the only way to improve your debt-to-income ratio. That’s easier said than done, of course, but if your DTI is holding you back from buying a home, you should explore ways to bump up your take-home pay, including a second job.
2. Consider affordable alternatives to monthly debt
A lot of people wind up spending beyond their means on rent, car loans and other monthly debt payments. If you’re struggling to keep up with that debt, it may be time to consider more affordable options like taking on a roommate or finding an apartment in a neighborhood with less demand.
3. Stick to a budget
Some monthly debt is unavoidable, but other recurring costs like an outstanding credit card balance come down to personal choices. Take a hard look at where your money is going each month, and chances are you’ll find plenty of opportunities to scale back your expenses. First, you need to give yourself a budget that will give you the financial flexibility to pay down debt, cover living expenses and save up for a down payment — all while still letting you enjoy the little things about life.
Now comes the hard part: You have to stick to that budget. It’s OK to overspend in certain areas from time to time, but you need to offset those imbalances by pulling money from other budgeted items. So, if you wind up paying more than you expected on groceries one month, you could reduce the amount you had planned to spend on takeout or entertainment.
4.Cut back on credit card purchases
Scaling back on unnecessary expenses is always a fiscally responsible move, but reducing your dependence on credit card purchases, in particular, will help you meet your DTI goals. It’s way too easy to spend beyond your means by relying on credit cards and racking up more debt in the process. Credit card interest payments are another cost you simply don’t want to deal with if you’re trying to lower your debt-to-income ratio.
Excessive unpaid credit card balances also impact your credit score, which is another important factor that lenders will weigh when considering your mortgage application. So, for the sake of your homebuying aspirations, put the credit card back in your wallet whenever possible.
5. Focus on paying down debt
Debt-to-income ratios don’t look at how much money you have in the bank. They’re laser-focused on how much money you have coming in compared with the amount of debt you owe. As such, taking money you would have spent elsewhere and devoting to paying down your debt will help lower your DTI, even if the funds in your bank account stay the same or even go down.
Keep in mind, however, that when you’re applying for pre-approval of a home loan, lenders will look at your bank statements to see how much money you have on hand. So, if you’re going overboard paying down debt, that could hurt your loan application in other ways.
Your debt-to-income ratio is a key piece of information mortgage lenders will review when deciding if they should extend a home loan to a borrower — not to mention, what the terms of that mortgage agreement should be. Staying on top of your DTI both increases your chances of securing a home loan at a good rate and helps you figure out how much to spend on a new house. You can also check out a home affordability calculator to get a sense of what your homebuying budget should be.
DTI is one of several factors lenders weigh, so take the time to shore up any issues that might impact your mortgage application. No matter if you’re a first-time homebuyer or you've gone through this process before, it’s always wise to speak with a knowledgeable loan officer. They’ll understand what lenders are looking for in a borrower and can advise you on the best ways to improve your homebuying prospects and secure a mortgage.