As you shop for a home (and a mortgage to accompany it), you aren’t the only one who is reviewing your financial health. Lenders also examine several elements of it to better understand what kind of borrower and spender you are. One number that’s worth a thousand words? Your debt-to-income ratio. Here’s what lenders look for and what you need to know about debt-to-income ratios for a mortgage.
What is debt-to-income ratio?
Debt-to-income ratio, or DTI, is an industry standard measure to establish how much house you can afford. Expressed as a percentage, it shows how much of your money goes toward debt, giving you and lenders a clear picture of how much you can dedicate toward paying off a mortgage each month. If you’re getting ready to buy a home, the lower your DTI, the better.
How to Calculate Your Debt-to-Income Ratio
Your DTI is rather simple to calculate — just add up all your monthly expenses and divide by your monthly gross income (aka, your income before taxes, retirement contributions, etc.). But exactly which expenses should you include? Think: things like current rent or mortgage payments, car payments, student loans, child support, credit card minimums, and any other recurring payments you make month-to-month.
How much should your debt-to-income ratio be for a mortgage?
Whether you are taking out a mortgage for the first time or refinancing a loan you already have, lenders examine your DTI to assess the level of risk they will incur by lending to you. Typically, the higher your DTI the riskier you are to lenders, because it indicates you may be less financially able to make your mortgage payments. In turn, this can affect how much lenders are willing to let you borrow and at what interest rate.
Lenders usually prefer conventional loan borrowers (those getting a loan not backed by the government) to have a debt-to-income ratio of 36% or below — meaning roughly a third of your gross monthly income goes toward fixed debt payments and the rest is yours to spend on remaining wants and needs. Depending on the state of your financial health in other aspects, like your credit score, you may qualify for a loan with a DTI up to a maximum of 50%. Loans backed by the government, like FHA loans, typically accept borrowers with DTI ratios up to 43% and may go up to 57% in certain cases.
Two Variations of Debt-To-Income Ratio (DTI)
When you apply for a mortgage, lenders will evaluate your DTI in two ways, the front-end DTI and back-end DTI, to get an even better understanding of where your monthly income is headed.
Your front-end DTI looks at how much of your gross monthly income is going specifically toward housing costs. This includes payments like your monthly mortgage, private mortgage insurance (PMI), property taxes, and homeowner’s insurance. Lenders like to see a front-end DTI between 28% and 35%.
When you add up all your monthly expenses to measure your DTI, you’re technically calculating your back-end ratio. Like the front-end, it includes home-associated costs, but it also includes credit card payments, car loans, and more. This number is more important to lenders, as it provides a broader look at all your spending — but that’s not to say you should ignore your front-end ratio.
Tips to Lower Your DTI
If you aren’t happy with your current DTI, remember it isn’t a fixed number, and you can lower it by either increasing your monthly income or decreasing your existing debt. Whether you’re having trouble getting approved for a loan or are facing high interest rates, trying out these tips to reduce your DTI may help.
- Compare your credit card interest rates and pay down ones with the highest rates first.
- Use the 50/30/20 rules to create a budget you can stick to, that will help you manage your spending.
- Pay all bills on time to avoid piling on late fees.
- Get a side hustle — like ridesharing, tutoring online, selling clothes in the resale market, or a part-time restaurant or retail position.
Score the DTI you need for a mortgage
Your debt-to-income ratio is one number that holds a lot of weight when it comes to buying or refinancing a home. But even though it gives a snapshot of your financial health, it doesn’t tell the whole story. As you prepare to become a homeowner, work on lowering your DTI, while also keeping in mind the big picture of your finances. As you raise your credit score and increase your savings, you may just see your DTI improve as well.
Wondering how much house you can really afford?