What is debt-to-income ratio?
Your debt-to-income ratio is the amount of monthly recurring debt payments compared to your gross monthly income.
For instance, let’s say that your gross monthly income is $5,000. You have a total of $2,000 of recurring debt obligations, which include a car loan, rent, and a credit card balance.
To calculate your DTI ratio, you can divide your minimum payment and debts ($2,000) by your gross monthly income ($5,000). In this scenario, the result would be 0.40, or 40%. You want your DTI to be 50% or less because this provides enough financial leeway to cover other expenses.
Not all your monthly expenses are used to calculate DTI. Lenders will only examine certain bills and obligations when assessing your debt-to-income ratio. These include rent or mortgage payments, car loans, student loans, credit card debts, or other monthly debt payments. They also include recurring obligations like child support and alimony.
Your DTI does not include miscellaneous expenses like utility bills, home repairs, groceries, daycare, commuting expenses, health care/insurance, or car insurance.
How to calculate debt-to-income ratio for a mortgage
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Start by listing your relevant monthly expenses, such as rent, credit card bills, and car loans. Remember, do not include the cost of groceries, gas, utilities, childcare, commute, or health care/insurance.
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Calculate your gross monthly income by dividing your annual gross income by 12 or by reviewing four weeks of your most recent pay stubs.
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Divide your monthly debt payments by your gross monthly income. This calculation should yield a number between zero and one — for example, 0.40. This number is your DTI. It can be expressed as a percentage if you multiply it by 100. In this example, your DTI would be 40%.
Front-end and back-end DTI
Your debt-to-income ratio can be divided into two subtypes: front-end and back-end DTI.
Front-end debt-to-income ratio (housing expenses)
Front-end DTI is the ratio between your gross income and your current or projected housing expenses. This figure will include your base mortgage payment, property taxes, mortgage insurance, homeowners’ insurance, and homeowners’ association dues when applicable.
When evaluating your creditworthiness, lenders will assess your total DTI and your front-end DTI. Generally, lenders want your front-end DTI to be under 35%. However, some loan programs and lenders have slightly different thresholds.
Back-end debt-to-income ratio (debts)
Back-end DTI is generally larger than front-end DTI and represents the total recurring debts that you owe compared to your gross monthly income. The back-end DTI includes the front-end expenses (mortgage payment, property taxes, mortgage insurance, homeowners’ insurance, and homeowners’ association dues) and the recurring obligations we spoke of previously (car loans, student loans, credit card debt, child support, and alimony).
Breaking down DTI into front-end and back-end can help you better understand which financial obligations are making the biggest impact on your creditworthiness.
Tips to lower your debt-to-income ratio
If you’ll be applying for a mortgage soon and want to know how to lower debt-to-income ratio, remember these tips and tricks:
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Paying down debt is the most straightforward way to reduce your DTI. The fewer debts you owe, the lower your debt-to-income ratio will be. However, keep in mind that your DTI will not immediately decrease when you begin lowering your overall debt.
Suppose that you have a car loan with a monthly payment of $500. You can begin paying an extra $250 toward the principal each month to pay off the vehicle sooner. This extra cash will reduce your overall debt faster and save you money in interest.
However, your DTI will not drop until your car loan is paid in full. DTI does not take into account the total amount of debt you owe; instead, it analyzes your monthly expenses in relation to your gross monthly income.
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Debt consolidationis the process of combining multiple monthly bills into a single payment. You can consolidate debt by obtaining a personal loan and using those funds to pay off multiple loan payments, such as smaller loans and credit cards. The monthly payment of your debt consolidation loan will be lower than the cumulative amount of all of your old payments. Therefore, it will drop your DTI.
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When a lender pulls your credit report, the report will outline how much you owe. It will also detail your monthly payments on each of your outstanding debts. Therefore, you can lower DTI by decreasing your monthly payment amounts, even if you do not reduce your total amount owed.
The easiest way to reduce your monthly payments is to refinance existing loans to lower your interest rate. Dropping the refinance mortgage rate by just one or two percentage points can make a huge difference in your monthly payment, especially if the overall loan value is high. When using this method, consider refinancing car loans and consolidating credit cards into a single personal loan. These efforts can make you more qualified for a mortgage by lowering your DTI.
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Remember, your debt-to-income ratio is the amount of recurring monthly debt that you have compared to your income. You can reduce your DTI by lowering monthly debt payments — or by increasing your income.
The latter approach is a great option if you are close to the DTI ratio you need to be at to obtain a loan but need a little boost to get there.
If you want to boost your gross monthly income, consider getting a side hustle. You could deliver food, offer ride-sharing services, or make and sell crafts online. You will need to generate a consistent amount of income using your side hustle for 2 years before lenders recognize this additional revenue stream.
Therefore, you should work on increasing your income soon so that you will be able to obtain the loan you need when you are ready to buy a home.
Perhaps you are scheduled for a raise or promotion that will generate additional income. Or it may be time to consider a higher paying position or company.
Getting a loan with a high debt-to-income ratio
While most lenders want your DTI to be less than 50%, there are instances where you may qualify for a loan with a high debt-to-income ratio. You may still be able to qualify for a type of home loan by working with a local loan officer.
For example, if you are self-employed, your W2s might not accurately reflect your true income. As a result, your DTI will appear unusually high even if you are in good financial health. A Non-QM loan solution may best fit your unique financial situation.
