When you are thinking about buying a house, you’re probably envisioning the memories you’ll make in your new home, the great family dinners and nights hanging out with friends. Your thoughts may not initially stray into terms like “debt-to-income (DTI) ratio” or “credit score.”
You will be more familiar with terms like these as you undergo the mortgage process. In this article we’ll cover everything you need to know about DTI. Lenders like to take an in-depth look at your DTI ratio to make sure you don’t carry too much debt. A high DTI ratio could signal to mortgage lenders that your financial situation makes you a riskier borrower with the potential to default on your mortgage loan.
We’ll walk through the critical question of this piece: “What is debt to income ratio?” and also go over how to calculate debt-to-income ratio.
What is Debt-to-Income or DTI Ratio?
Debt-to income ratio (DTI) involves calculating the percentage of your debt obligations against your monthly gross income. In other words, the ratio compares your overall debt to your income.
DTI Formula and Calculation
Calculating your DTI involves using the following formula:
Monthly Bills ÷ Gross Monthly Income (income before taxes) = DTI Ratio
What monthly bills are included in your DTI ratio? These bills refer to your fixed monthly expenses. Monthly bills do not include payments that vary each month, such as utility bills, gas, minimum credit card payments due or any other types of variable bills or payments.
Your DTI ratio calculation should only include fixed payments such as rent payments, auto loan payments, alimony, child support, student loan payments and other fixed payments.
Your gross monthly income, on the other hand, refers to the amount you earn before any taxes or deductions get taken out of your account. Learn more about how to calculate debt-to-income ratio here.
Debt-to-Income Ratio Examples
Let’s walk through a quick example of how to calculate DTI. Let’s say you have the following fixed monthly expenses:
- Student loan payment: $500
- Rent: $800
- Alimony: $400
- Personal loan payment: $500
- Gross monthly income: $6,000
When added, these fixed expenses equate to $2,200. Divide this amount by your gross monthly income ($6,000).
DTI Ratio = $2,200 ÷ $6,000
DTI Ratio = 37%
Why is DTI Important in Personal Finance and Loans?
Lenders want to know the percentage of your gross monthly income that goes to paying your monthly debt payments because they use it to determine how risky you are as a borrower as well as the monthly payments you can afford and rates for which you may be eligible. The lower your debt-to-income (DTI) ratio, the better, because lenders use your DTI to calculate your interest rates and terms.
Types of Debt-to-Income Ratios
Lenders check two types of ratios: front-end DTI ratio and back-end DTI ratio. Front-end DTI comes from housing expenses divided by gross income. Back-end DTI, on the other hand, comes from the percentage of gross income spent on other debt types, such as credit cards or car loans.
- Front-end DTI ratio: To calculate front-end DTI, add up your expected housing expenses (such as mortgage payments, mortgage insurance, etc.) and divide it by your gross monthly income to get your front-end DTI ratio. Let’s say that you currently have a $2,000 mortgage payment and you bring in $6,000 per month in gross monthly income. In this example, your front-end DTI ratio would be 33%.
- Back-end DTI ratio: You can calculate back-end DTI ratio by adding together your monthly debt payments and dividing the sum by your monthly income. Back-end DTI ratio looks like the example we went over earlier in this article: $6,000 ÷ $2,200 = DTI Ratio (37%).
What is a Good Debt-to-Income Ratio?
You may wonder about what DTI ratio percentage you should aim for. Let’s walk through the ideal DTI ratios for mortgages.
Good DTI Ratios for Mortgage (What Do Lenders Require?)
Try to aim for as low of a DTI as possible. Lenders typically want to see a DTI ratio of 43% or lower, though this requirement depends on your loan type. Lenders check your DTI ratio because they want to loan to borrowers who have a lower risk of defaulting on their loans.
Why Do Lenders Check Credit Utilization Ratio and What is it?
Credit utilization ratio refers to the amount of credit you use from all your available credit sources. In other words, it refers to the amount you currently owe divided by your credit limit. Let’s say you currently owe $1,000 on your credit cards and your credit limit is $10,000. In this case, your credit utilization ratio is 10% ($1,000 ÷ $10,000 = 10%).
Lenders check your credit utilization ratio in addition to your DTI because they want to know how much of your available credit you use. Like DTI, you want to keep this as low as possible though under 30% is generally considered to be the goal.
Debt-to-Income Ratio (DTI) Limitations
DTI has some limitations. One limitation is it doesn’t take into account the interest rate of various loan types.
In addition, your DTI doesn’t show other factors about you, such as whether you have larger down payments, a larger amount in emergency savings, a good credit score and other factors.
How to Lower (Improve) Your Debt-to-Income Ratio
You can take a few approaches to lower and improve your DTI ratio:
- Limit and improve spending habits: Reducing your spending habits can change your DTI for the better. For example, you may consider putting less on your credit cards per month as a way to lower your DTI.
- Make a budget: Consider using a budget to lower your DTI ratio. Budgeting may allow you to put more money toward your debt each month instead of spending excessively.
- Reduce debt: Making extra payments toward your debt can reduce your debt load. Consider paying off high interest debts first before you tackle other types of debt. Think about debt consolidation as a means to pay off debt faster. Debt consolidation means you roll multiple debts (such as credit card debt and personal loans) into a single payment to get a lower interest rate.
- Avoid fresh credit: Avoid taking on additional loans when you are applying for a home loan. Having new hard credit pulls can increase your DTI.
Does Your Debt-to-Income Ratio Affect Credit Score?
Your DTI doesn’t impact your credit score, the three-digit number that shows how well you pay back debt. However, lenders do evaluate your credit score when deciding whether or not to approve your mortgage loan.
You will want to look at your credit report prior to getting a mortgage loan to ensure it is accurate. Sometimes information on individual credit reports showcases the wrong information. For example, your credit report might state that you defaulted on a personal loan that you never took out — it could have misinformation from someone who has the same name as you.
Bottom line: It’s a good idea to use credit responsibly at all times and pay attention to your financial health.
Frequently Asked Questions About Debt-to-Income Ratio
What debt-to-income ratio is too high?
Ideally, you should have a DTI of less than 43%. However, no single set of requirements indicates the “right” DTI for every individual who applies for a loan. The DTI requirement depends on your personal financial situation and the exact loan you apply for.
Do student loans count in debt-to-income ratio?
Yes, they can. If you calculate your debt and student loans make up a portion of your consistent, recurring debt, you can add them to your DTI ratio calculation.
Can I get a loan with a high debt-to-income ratio?
Yes, it’s possible to get a loan with a high DTI ratio, because DTI isn’t the only factor considered in your overall application. You can look into government-backed loans, such as FHA, USDA or VA loans. You have the ability to hit the “pause” button on getting a new home by restructuring your debt or consolidating your payments. This will allow you to take time to pay down your debts.