Both first-time and repeat home buyers often think of their credit score as the first number to obtain before applying for a loan. That’s only one piece of a larger picture that lenders gather when assessing your risk and ability to pay back a mortgage loan. Your debt-to-income (DTI) ratio is equally important. A credit score focuses on how often you paid bills on time. DTI ratio focuses on the actual debt you’ve accrued and the income you have to pay it off. Anyone who’s thinking of buying a home needs to understand this concept.
What is Debt-to-Income Ratio?
Debt-to-income ratio is your monthly debt payments divided by your gross monthly income. Lenders use this number to measure your ability to manage the monthly payments to repay the money you plan to borrow from them. DTI ratio compares your regular monthly debt to your regular monthly income. It’s expressed as a percentage and shows how you’re managing your debt. A lender wants to know how much money you have left after paying off regular debt payments each month. This number is not only useful to a lender, it’s a good way for you to understand how financially healthy you are (or aren’t).
How is Debt-to-Income Ratio Calculated?
If you want to calculate your DTI ratio on your own, follow these steps:
1. Add up your monthly bills, which might include any of the following:
∙ Monthly rent or house payment, including monthly HOA fees
∙ Monthly alimony or child support payments
∙ Student, auto, and additional monthly loan payments
∙ Credit card payments – use the minimum payment for all credit cards
∙ Other debts
Expenses such as food, utilities, gas, monthly subscriptions, cable/satellite, health and auto insurance, cell phone bills, and taxes are not included as debt.
2. Divide the total debt from step one by your gross monthly income (before taxes). In addition to a paycheck, include any recurring source of income, such as:
∙ Alimony
∙ Child support
∙ Social Security benefits
∙ Rental income from real estate you own
∙ Lottery winnings annuities averaged monthly
∙ Pension income
Lenders probably would not include one-time income, such as gambling winnings.
3. The calculation from step 2 is your DTI ratio, expressed as a percentage. The lower your DTI ratio, the less risk you are considered to a lender.
Let’s say your total monthly debt is $2,500 and your monthly gross income is $5,000. $2,500 divided by $5,000 equals 0.50. Multiply by 100 to express as a percentage. Your DTI ratio is 50%.
What Does My Number Mean?
Each lender makes its own standards for acceptable debt-to-income ratios. In general, however, we can say that if you are applying for a conventional loan, a DTI ratio should be lower than 43% and preferably under 36%. Federal Housing Administration (FHA) loans can sometimes allow for higher DTI ratios if certain circumstances are met and the borrower meets FHA qualifications. Here are implications by DTI ratio range:
Under 36%: You’re dealing well with your finances. Most lenders will be happy to work with you.
36-42%: You may be overextended with too much debt and not enough income. Make paying off debt a priority. You still may be able to secure a loan.
43-50%: You have a high debt level. It may be wise to hold off on buying a home until you reduce the amount you owe. Consider working with a credit counselor.
Over 50%: It will be very difficult to get a mortgage without decreasing your debt and increasing your income. Look into all options for paying down debt and reducing financial obligations.
How Can I Improve My DTI Ratio?
Simply stated, the best ways to lower your debt-to-income ratio is to increase income and lower debt. Consider any of the following strategies for lowering your debt:
∙ Pay off highest interest debt first. Pay more than the minimum amount to save on future interest costs.
∙ Reduce the interest paid on loans, like transferring debt from one credit card to another with a lower interest rate or refinance an auto or personal loan.
∙ Find a “side hustle” for additional income that fits outside of regular working hours.
∙ Limit non-essential spending so more of your income can be used to pay off debt sooner.
While debt consolidation is another way to lower DTI ratio and lower interest payments, keep in mind that it can adversely affect your credit score.
Real Estate Term of the Week
FHA Loan: A type of government-backed mortgage loan that can allow you to buy a home with looser financial requirements. You may qualify for an FHA loan if you have debt or a lower credit score. You might even be able to get an FHA loan with a bankruptcy or other financial issue on your record. FHA stands for Federal Housing Administration.