What is a debt-to-income ratio?
According to the Consumer Financial Protection Bureau, your debt-to-income ratio (DTI) is a calculation of all of your monthly debt payments divided by your gross monthly income. This is typically shown as a percentage in which lenders view the DTI ratios in developing their risk profile. For mortgage loans specifically, 43% is looked at as the highest ratio a borrower can have and still get a qualified mortgage. This is because those borrowers that have a high DTI are more likely to not make their monthly payments.
What is included in debt to income ratio?
The DTI ratio is made up of front-end ratios and back-end ratios used by mortgage lenders. Below is a breakout below of each:
This is the % of your monthly gross income that goes towards housing expenses. This includes the following:
monthly mortgage payments
- property taxes
- homeowners insurance
- homeowners association dues (HOA)
The % of your income that covers your debts plus mortgage payments and housing expenses. This includes the following:
- credit card bills
- car loans
- child support
- student loans
- additional debt that shows on your credit report.
How to calculate your debt-to-income ratio?
To calculate your DTI, add up all of your monthly debts that includes the following:
- mortgage payments or rent payments
- student loan payments
- personal loan payments
- auto loan payments
- minimum credit card payments
- child support payments
Next, divide the sum of your monthly debts and divide it by your monthly income. Your gross monthly income is the amount of money you have earned before your taxes and other deductions..
Here is an example of how to calculate your DTI:
You pay $2000/month for your mortgage, $150/month for your auto loan and $350/month for the rest of your debts, your monthly debt payments are $2500. Your gross monthly income is $8000. Divide your recurring monthly debt of $2500 by your gross monthly income of $8000 and your debt-to-income ratio is 31%.
Check out our calculator below to see what your DTI is:
What is a good debt-to-income ratio?
Ideally, a front-end ratio should be no more than 28 percent and the back-end ratio should be 36% or lower. The front-end ratio is the mortgage-to-income ratio that is calculated by dividing your anticipated monthly mortgage payments by their monthly gross income, whereas the back-end ratio factors in additional expenses and debts. A DTI of 36% allows you some room to accommodate potential changes in your income and expenses. Obviously, the lower the DTI is, the better your probability is at getting a qualified mortgage and, better yet, the best rate. Outside of your DTI, lenders typically weigh your credit score, savings, assets and down payment, when evaluating if you can qualify for a loan, so lenders may accept higher DTI ratios.
Does DTI impact my credit?
Your DTI ratio has little bearing on your actual credit score, but typically borrowers with a high DTI ratio may also have a high credit utilization ratio. This accounts for 30% of your credit score.
How to calculate your credit utilization ratio?
Your credit utilization ration is the balance on your credit accounts compared to your maximum credit limit. An example is if you have a credit card with a $5,000 limit and have a credit card balance of $2,500, your credit utilization ratio would be 50%. Typically, you want to keep this below 30% when you apply for a mortgage.
How can you lower your debt-to-income ratio?
If you are looking to lower your DTI ratio, the following are great options:
Create a Budget
Track your expenses and make sure you pay down your debt
Create a strategy to pay off your debts
- snowball method
- pay down your small credit balances first and make minimum payments on others
- ladder method
- pay down the balance on your accounts with the highest interest rate first, then work your way down.
Lower the rates on your debts
- Call your credit card company to see if you can lower your rate
- Consolidate your credit card debt by transferring high interest credit card balances to a new card with a lower rate
- Get a personal loan to consolidate your debt into a loan with a lower interest rate and one monthly payment
Stop taking on more debt
- Make it a point not to take on new loans
- Stop making large purchases on credit cards
Your DTI ratio is a great measure of your financial stability. The lower it is, the better, as this means your debts are much more affordable. If you do have a high DTI, there are steps that you can take including budgeting or paying down your debts to start getting this ratio lower.