DTI, or the debt-to-income ratio, refers to a personal finance measure. This ratio compares the debt payments you pay every month to your monthly gross income. Your gross income represents your income before any deductions or taxes.
Let’s find out about the different types of debt-to-income ratios. Then, we’ll cover why they are essential for your mortgage loan application.
Generally, lenders divide the information that comprises a debt-to-income ratio into different categories; the back-end ratio and the front-end ratio.
The front-end ratio includes the debt directly related to a mortgage payment. You can calculate this ratio by adding all real estate taxes, homeowner’s insurance, mortgage payment, and homeowner’s association fees. Now, divide this amount by your monthly income.
For instance, if your taxes, insurance, and mortgage payment add up to $2,000 and your monthly income is $6,000, you will get a front-end ratio of 30% by dividing 2,000 by 6,000.
Generally, lenders want to obtain a front-end-ratio of 31% or less for FHA or Federal Housing Association loans and 28% or less for conventional loans. A higher front-end-ratio means you are at a higher risk of getting a higher interest rate if you apply for a loan.
Back-end ratios are the same as debt-to-income ratio since it includes all debt related to your mortgage payment, as well as ongoing debts such as auto loans, credit card bills, child support payments, student loans, etc.
How to Calculate DTI
Your lenders will use this ratio, measuring your ability to repay debts or manage your monthly debt payments.
Here are the steps to help you calculate DTI:
Add up your monthly debt payments, such as loans, mortgage, and credit cards.
Divide this amount by your monthly income (gross)
You will get a decimal value, so multiply it by 100 to get your DTI percentage.
A borrower can qualify for a mortgage loan if his DTI ratio is not more than 36%. However, 43% is the highest percentage a borrower can have to qualify for a mortgage. But the maximum DTI ratio can vary from lender to lender. The lower your DTI ratio is, the better your chances are for receiving a loan. So before you decide to make a big purchase, don’t forget to calculate your DTI ratio.
Let’s say you want to qualify for a loan, and you are trying to determine your DTI ratio.
Take this simplified breakup of monthly income and bills as an example:
Gross income: $1,000
Credit card bills: $500
Car loan: $500
To calculate your DTI ratio, you will divide your monthly debt payment by your gross income.
Total Debt: $1,000 +$500+$500
DTI Ratio: $2,000/$6,000 = 0.33
Convert this decimal value into a percentage by multiplying it with 100 = 33%
You have a 33% DTI ratio. Lenders will consider this ratio as it represents the percentage of your monthly income that will go into your monthly debt payments.
Tips for Lowering your DTI
One of the best tips is not to apply for a loan when your DTI is exceptionally high, for instance, 50% or more. Although a pay raise is a great way to lower your DTI, wait for the right time to apply for a loan. Most lenders will not consider your student or car loan payments as part of your DTI if you have a few months left to pay them off. Avoid taking on more debt and whittle down the debt you already have is the best tip to lower your DTI. Using a specific calculator to determine your DTI ratio can help you gauge your financial position before you apply for a mortgage loan.