Securing your dream home can be overwhelming, especially if you’re unfamiliar with the terminology that might come up during the mortgage application process. One term you should be aware of when applying for a home loan is your debt-to-income (DTI) ratio. The DTI ratio is a snapshot of how much debt you have compared to your income.
So, how do you calculate your debt-to-income ratio? Why do lenders care about this metric? And how do you improve your DTI to increase your chances of mortgage approval? Let’s take a closer look.
- What is a DTI ratio?
- Types of debt-to-income ratios
- How your DTI is calculated
- What is a good ratio for a mortgage?
- How to lower your debt-to-income ratio
What is a debt-to-income ratio?
As its name suggests, your debt-to-income ratio (DTI) is calculated by dividing your total monthly debt payments by your gross monthly income. This number gives lenders insight into how much of your monthly income goes towards debt payments and helps them assess the risk in lending you money.
Generally, a low DTI indicates that your debt is manageable relative to your income. On the other hand, a high DTI could suggest that you’re living beyond your means or struggling to meet debt obligations.
Types of debt-to-income ratios
Mortgage lenders typically look at two types of debt-to-income ratios when evaluating your financial readiness: front-end DTI ratio and back-end DTI ratio.
Front-end DTI ratio
Also known as the housing ratio, the front-end DTI ratio calculates how much of your monthly income goes toward housing-related expenses such as mortgage payments and homeowners insurance.
Back-end DTI ratio
Your debt-to-income ratio, also known as the back-end DTI ratio, calculates how much of your gross monthly income goes into debt payments, such as your mortgage, credit card payments, and student loans. Lenders typically focus more on your back-end DTI ratio since it gives them a more complete picture of your finances.
How debt-to-income ratio is calculated
So, how is DTI for mortgages calculated? To help you better understand how it works, imagine you have a gross income of $5,000 a month, and these are your monthly debt obligations:
- Student loan payments: $250
- Auto loan payments: $150
- Personal loan payments: $550
- Credit card payments: $150
- Monthly mortgage: $1,000
- Child support: $500
To calculate your front-end DTI ratio: Add up your total housing expenses and divide the sum by your gross monthly income. Then, multiply that number by 100. In this case, you’d take your $1,000 mortgage payment and divide that amount by your gross monthly income of $5,000 to get 0.2, or a 20% front-end DTI ratio.
To calculate your back-end DTI ratio: Add up all your monthly debt payments and divide the sum by your gross monthly income. Then, multiply the result by 100. In this case, you’d take the $2,600 in monthly debt payments and divide that amount by your gross monthly income of $5,000 to get 0.52, or a 52% back-end DTI ratio.
What is a good debt-to-income ratio for a mortgage?
A good back-end DTI for mortgage applications is any number below 36% — but the lower, the better. Although each lender’s DTI ratio requirement may vary, in most cases, the highest back-end DTI ratio acceptable is 50%.
When your DTI exceeds 50%, half of your income goes to repaying debt each month, which means you’re financially overextended. In this case, lenders might see you as a risky borrower and reject your loan application.
Apart from your back-end DTI ratio, mortgage lenders may also consider your front-end DTI ratio. Most lenders like to see this ratio below 28% for conventional mortgages, or 31% for Federal Housing Administration (FHA) loans.
How to lower your debt-to-income ratio
Don’t be discouraged if your debt-to-income ratio is currently above or close to 50%. With determination and perseverance, you can lower this ratio to more favorable levels. Here are a few tips to help you regain control of your finances and improve your DTI:
1. Pay off existing debt
First, set a concrete goal regarding how much debt you need to pay off. For example, if you’re aiming for a DTI ratio of 36% and your gross monthly income is $5,000, you need to get your monthly debt obligations below $1,800.
Once you’ve set a target, start budgeting and tracking where every penny goes to identify unnecessary expenses you could allocate toward debt repayment.
If you’re still struggling to lower your debt despite sticking to a budget, consider loan consolidation and refinancing options to reduce your interest payments.
2. Boost your income
Another effective way to achieve a good DTI ratio for mortgage applications is by increasing your cash flow. If you have some free time outside your working hours, consider supplementing your primary income with side hustles such as freelancing, waiting tables, dog walking, or reselling items online.
If you don’t have time to take on a part-time job, you could also consider negotiating a pay raise with your current employer. This way, you can bring in additional income without taking on extra hours.
3. Avoid applying for new credit
While it’s tempting to jump at a new offer for a credit card, it can leave you with too much debt on your plate. To keep your DTI ratio in check, avoid taking on additional debt and focus on paying down existing balances. Remember, if you take on more debt without increasing your income, you’ll be further away from achieving a low DTI ratio.
4. Add a co-borrower
Lenders typically consider the debt expenses and monthly gross income for all co-borrowers when calculating the DTI ratio. So if your DTI ratio is less than ideal, consider adding a co-borrower with a good DTI to increase your chances of approval.
Keep in mind that since both co-borrowers are liable for repaying the loan, missing payments, or defaulting on the mortgage could hurt both of your credit scores. So be sure to choose someone you can trust as your co-borrower.