When you first embarked on the journey of buying a home, you likely turned to online resources for preliminary insights. Perhaps you pondered the information you’d need to share with a lender or mortgage broker as part of the homebuying process. Here’s a vital piece of that puzzle: Lenders place a significant emphasis on evaluating your debt-to-income (DTI) ratio.
But what exactly does the term ‘DTI ratio’ entail?
Your debt-to-income ratio (DTI) signifies the proportion of your debt commitments relative to your monthly gross income. Lenders scrutinize this ratio to ensure you’re not burdened with excessive debt – a high DTI ratio might indicate a potential risk of defaulting on your mortgage loan.
In the following sections, we’ll guide you through the process of calculating your debt-to-income ratio, provide practical examples illustrating its application, and discuss strategies to enhance your DTI ratio.
Debt-to-Income (DTI) Ratio Calculation Method
Here, we’ll take a look at the easiest way to calculate your own DTI ratio. Don’t worry, calculating your DTI ratio doesn’t involve a complicated algebraic equation!
First, you can calculate your debt by adding up your fixed monthly expenses. Note that you only want to include payments that don’t vary each month. Your DTI ratio calculation should only include fixed payments such as:
- Rent or mortgage payment
- Property taxes and homeowners insurance (if not part of your mortgage payment)
- Homeowners association dues
- Child support payment
- Student loan payment
- Auto loans or car loans payment
- Personal loans
- Fixed installments on credit card debt
- Other recurring payments
Don’t add regular expenses into your calculation, including:
- Utility bills
- Other variable bills or payments, like credit card payments, which change each month
Next, use the following formula to calculate your DTI ratio:
Monthly Bills ÷ Gross Monthly Income (income before taxes) = DTI Ratio
You can include the following sources of monthly income in your calculation: your wages or salary, pension, Social Security payment, child support and alimony and/or other additional income, such as income you earn from a side hustle.
Let’s look at an example of how to calculate your DTI ratio. Say you make the following debt payments every month:
- Rent: $1,500
- Student loans: $1,000
- Personal loan: $500
We’ll also say you make $7,000 per month before taxes.
In this case, the calculation looks like this: $3,000 ÷ $7,000 = 0.4285
Now, multiply the results by 100 to get a percentage and round up: 0.4285 x 100 = ~43%.
Types of Debt-to-Income Ratio Calculation
DTI ratio gets a little more nuanced when lenders check your front-end DTI ratio and back-end DTI ratio. What does this mean? Let’s take a look.
- Front-end DTI ratio: Your front end ratio includes only housing-related expenses, such as your future monthly mortgage payment, with property taxes and homeowners insurance included.
- Back-end DTI ratio: The math problem we shared above calculates your back-end DTI ratio. In addition to housing costs, the back-end DTI ratio includes any other recurring monthly payments, such as student loans and auto loans. Your back-end DTI ratio gives lenders a more comprehensive picture of how much you spend each month.
What is Considered a Good DTI?
Once you complete the calculation, you’ll want to know what the calculation means — is it good or bad? We’ll go over what lenders require, the definition of credit utilization, why it’s important and why you may want to improve your DTI ratio.
Good DTI Ratios for Mortgage (What Lenders Require)
The lower your DTI ratio, the better. Lenders generally want to see a DTI ratio of less than 43%. Lenders check your DTI ratio because they like loaning to borrowers who demonstrate a lower risk of defaulting on their mortgage loan. Your DTI ratio isn’t the only thing that lenders want to see, but it’s an important component of the lender’s process.
Why Do Lenders Check Credit Utilization Ratio and What is it?
Your credit utilization ratio measures how much credit you use compared to your credit limit. Together, your credit utilization ratio and DTI ratio both affect your mortgage loan.
You can use this calculation to determine your credit utilization ratio:
Current Balance ÷ Credit Limit = Credit Utilization Ratio x 100
For example, let’s say that you have a $15,000 credit card limit and as of this month, you have used up $5,000 of that limit. In this example, you have a 33% credit utilization ratio.
A good rule of thumb you can consider applying to your own situation: Keep your credit utilization below 30%.
Why Is a Good Debt-to-Income Ratio Important and Why Should You Improve Your DTI Ratio?
A low DTI ratio shows a lender that you have a good handle on your debt and income. If you have a DTI ratio of 10%, this means that you don’t spend a large majority of your gross monthly income on debt payments each month.
On the other hand, your lender might decide you have too much debt for the amount of income you earn if they see a high DTI ratio. You may want to consider improving your DTI ratio for this reason.
How to Lower (Improve) Your Debt-to-Income Ratio
Ready to lower your DTI ratio? Let’s go over a few tactics to accomplish your goal.
- Limit and improve spending habits. Creating a budget and sticking to it can help you reduce your amount of credit card swipes or other debt.
- Reduce your debt. Consider paying off all forms of debt, including paying off student loans. Becoming debt-free is an effective strategy to improve your DTI ratio.
- Pay off high-interest debts first. Have you ever heard of the debt avalanche method? In this debt payoff technique, you can make the minimum payments on all debts, then put extra payments toward your high-interest debt.
- Avoid taking on new credit. Consider skipping the financing on a new set of furniture for the time being or applying for new credit cards. It can help you improve your DTI ratio. Furthermore, taking on new credit might make it more difficult for you to fulfill your financial obligations.
Does Your Debt-to-Income Ratio Affect Credit Score?
Your DTI ratio doesn’t impact your credit score, which is a three-digit number that shows how well you pay off debt. However, lenders will take both your DTI ratio and credit score into account to evaluate your eligibility and terms for a mortgage.
It’s a good idea to keep tabs on your credit history using annualcreditreport.com or creditkarma.com, two credit reporting service options. However, these options may not produce the same results as an actual credit inquiry.
Frequently Asked Questions About Debt-to-Income Ratio
How do you calculate debt to income ratio if you’re self-employed?
You may wonder if you calculate your DTI ratio using a percentage of your gross income when you run your own business. After all, your gross monthly income may fluctuate quite a bit because you don’t receive a regular paycheck like you would with an employer. To calculate your debt to income ratio, Divide your total monthly debt by your gross monthly income (before income taxes).
To become qualified for a mortgage as a self-employed individual, your lender or broker may ask for your last two years of income and expenses as well as current year profit and loss statements. Business and personal tax returns and bank statements supporting ongoing income will likely be requested as well.
What debt-to-income ratio do I need to buy a house?
You want to try to keep your DTI ratio under 43%. However, remember that your DTI ratio doesn’t represent the only factor in determining whether you qualify for a mortgage. Many other factors become part of your overall snapshot.
Getting a mortgage can be complicated. Let Morty’s mortgage experts help you from start to closing.