How to calculate it and why it’s important to know before you apply for a mortgage
Your income is an important part of your mortgage application, but it’s not the only number mortgage lenders review.
Even with an impressive monthly paycheck you could find yourself unable to qualify for the loan requested or, worse, denied a loan entirely if you have a high debt-to-income ratio (DTI). Your DTI is an essential indicator lenders use to determine your creditworthiness and the ability to make your mortgage payments.
So what is a DTI? How do you calculate it? And how does it impact your homebuying options?
It’s actually pretty simple—let’s dig in!
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What is debt-to-income ratio?
You already know finances play a huge role in the homebuying process. In order to apply for a mortgage loan—and show how much money you have—you’ll need to provide everything from recent pay stubs and tax forms to current bank statements.
But how much money you owe is also an important piece of the homebuying puzzle. That number—the money you pay towards any debt each month—divided by your monthly income is your DTI.
In other words, DTI tells you what percentage of your monthly income you actually get to keep once your monthly debt obligations are paid.
It makes sense, right? If you keep your debt levels low and in line with your income—and have a history of making payments towards those debts on time—lenders will see you as financially responsible.
Meanwhile, if you have a high DTI, it means you have more debt payments amounting to a higher total and and may represent a higher financial risk as a borrower.
What is your debt-to-income ratio?
Your debt-to-income ratio is your monthly debt obligations compared to your total monthly income.
Your debt includes everything from credit card and car payments to student loans and the payment of items such as child support. If you owe money on it, it’s debt and it should be counted in your DTI.
Let’s look at it as a box of donuts — donuts make everything better.
Every month, you get one dozen donuts to take to a donut party. Delicious! But every month, before the party, you also have to give two donuts to your dog-walker and one donut to your mailman. You also have to give a donut to your landlord.
While your donut income may be 12, you can’t take 12 donuts to the donut party because every month you have to give away four of your donuts. The donut party organizers care less about how many donuts you start with every month and more about how many donuts you actually bring to the party. After all, you can’t eat donuts you don’t have!
In this example, your monthly donut debt is 4 and your monthly donut salary is 12. Four divided by twelve is .33, or 33%. So, your debt-to-donut ratio is 33%. Not bad!
What is a good DTI?
So what’s a good DTI? While the maximum DTI will vary by lender and the loan product you choose, most lenders consider anything under 36% as “acceptable” for a DTI ratio but there are other factors that lenders consider also, such as credit score, employment history, etc.
Lenders look at your DTI to get a snapshot of your financial stability and your ability to make the new mortgage payments along with your other debt payments. If you have a lot of accrued debt, even if you have a large income, they may consider you to be more of a risk than someone who has less debt.
If your debt-to-income ratio is higher than 36% some lenders may still work with you, but it might cost you—their loan offer may be smaller or come with higher interest rates.
Why is knowing your DTI important?
One of the most essential things to do before applying for a mortgage is to figure out your DTI. Knowledge is power—especially when buying a home and knowing your DTI gives you a better idea of what your budget may be and what kinds of loans to focus on.
Depending on your DTI, you may qualify for one kind of loan over another. Or, if you know your DTI is a little higher than the target 36%, you may be able to plan a budget that makes room for higher monthly mortgage costs. And if that’s the case, maybe you’ll want to apply for an adjustable rate mortgage, if one is available with your chosen lender.
The point is, you’ll want to know ahead of time where your DTI stands so you can make informed decisions.
Once you know your DTI, you’ll know how the mortgage lenders see you, on paper at least, and you will be able to work towards a home loan that fits your needs.
Most importantly, consider improving your DTI before you apply for a mortgage. Also, the maximum DTI will generally vary by lender and loan product type, so shop around a little bit. You can look at other types of loans, too.
How is your DTI calculated?
While the concept of the debt-to-income ratio may feel like a number-crunching nightmare, it’s actually very easy to calculate your DTI. Just think back to the donuts!
For your total debts, add up all your monthly debt payments. Include auto loans, student loans, credit card payments, personal loan payments, all of it. When calculating DTI, use total monthly payments, not your total overall debt.
Calculate your DTI by dividing your total monthly debt payments by your total monthly gross income (your income before taxes). For example, if your total monthly debts, including your projected new mortgage payment is $2,500 and your total gross monthly income is $7,500—your calculation is $2,500 divided by $7,500 which equals 33%. In this case, the DTI is 33%.
What can you do for a better DTI?
The best way to improve your debt-to-income ratio is to increase your income or decrease your debt. Easier said than done, right?
To reduce your DTI ratio, take a good look at your budget. Where can you cut costs so that you can pay off some of your debt sooner?
Also, are you so excited about buying a house that you’re already putting aside money each month for a down payment? If so, consider pausing that savings goal and instead throw that money at your debt. You might want to save some and use some to pay down your debts.
Less debt means a lower debt-to-income ratio and a lower debt-to-income ratio can result in a better home loan.
What is your debt-to-income ratio and why does it matter?
Your DTI tells you how much of your income is going toward paying debt each month. You already know how much you earn each month but DTI tells you how much you actually get to keep after you make your debt payments.
It’s important to know your DTI before applying for a mortgage because it can inform your budget, what kind of loan you apply for, and more.
Knowledge is power. The more familiar you are with your financial situation—and the more familiar you are with what lenders look at—the more power you’ll have when looking for a lender and home loan that’s right for you.
Don’t be afraid of your DTI, embrace it! Crunch those numbers and make it work for you.