If you plan to buy a home or car — or make any purchase that requires a loan — it is essential to have a good debt-to-income ratio. Your DTI reveals how much of your income goes toward debt payments each month, and this ratio gives lenders a snapshot of your financial condition and how likely you are to pay back your loan.
A good DTI may help get you a loan at the best rates, but a bad DTI might prohibit you from getting a loan at all.
“Getting over-leveraged and having too much debt compared to your income can be like a house of cards: One little gust of wind can send the whole thing toppling down,” says Evan Henderson, a certified financial planner with Northright Financial in Appleton, Wisconsin.
Before you shop for a home loan, make sure you understand how debt-to-income ratio works and how you can improve your DTI.
What Is Debt-to-Income Ratio?
Calculating a debt-to-income ratio is as simple as taking all of your outstanding monthly debts and dividing them by your monthly income. Typically, gross monthly income is used — which is what you earn before taxes and deductions.
This gives lenders important insights into your ability to pay back a loan, and the lower your DTI, the better. “It means you have more money to pay off debts, which makes it less likely for you to miss payments,” says Anna Sergunina, a certified financial planner and president and CEO at MainStreet Financial Planning in Los Gatos, California.
A lender will use your DTI to determine whether to approve a loan, how much you can borrow and at what interest rate. A low DTI “makes lenders see you as reliable, so they offer you loans with lower interest rates and better conditions,” Sergunina says.
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Front- vs. Back-End DTI Ratios
When you borrow, lenders scrutinize two aspects of your DTI — the front-end ratio and the back-end ratio.
The front-end ratio includes your housing expenses and consists of your principle, interest, taxes and insurance. According to the Federal Deposit Insurance Corp., lenders typically want the front-end ratio to be no more than 25% to 28% of your monthly gross income. The back-end ratio includes housing expenses plus long-term debt. Lenders prefer to see this number at 33% to 36% of your monthly gross income.
[Read: Best Mortgage Refinance Lenders.]
What Is a Good DTI Ratio for a Mortgage?
Debt-to-income ratio requirements vary, but as a general rule, lenders want to feel comfortable that your current debt load is low enough that you’ll be able to repay a debt as large as a home loan. “A strong debt-to-income ratio would be less than 28% of your monthly income on housing and no more than an additional 8% on other debts,” Henderson says.
However, other lenders may be willing to approve a mortgage even if your DTI is higher.
DTI Requirements by Mortgage Type
Different mortgages have their own DTI requirements, although precise requirements vary by lender. According to Experian, most lenders want to see a DTI below 43% to qualify for a conventional mortgage — and some may expect to see a DTI of 36% or lower.
However, other positive factors — such as a strong credit score or significant cash assets — might help secure a conventional mortgage even if your DTI is as high as 50%.
Borrowers looking to qualify for a non-conventional mortgage — such as those backed by the Federal Housing Administration or the Department of Veterans Affairs — will face different standards. To qualify for an FHA loan, you need a front-end ratio no higher than 31% and a back-end ratio of 43% or less, Experian says. An acceptable DTI ratio for a VA loan is 41%.
How to Calculate Debt-to-Income Ratio
Calculating a debt-to-income ratio is a relatively straightforward process. To find your DTI:
— Calculate all of your monthly debts, including a mortgage, auto loan, credit card bill and other obligations.
— Calculate your monthly gross income — the amount before taxes and deductions.
— Divide your monthly debts by your monthly income to produce your DTI.
For example, if your monthly debts total $3,000 and your gross monthly income is $7,500, your DTI is 40%. In essence, 40 cents of every dollar you make goes toward paying off debt, which is considered high. The Consumer Financial Protection Bureau recommends that homeowners keep their DTI at 36% or below, and that renters keep their DTI to 15% to 20% or less.
How Can I Improve My Debt-to-Income Ratio?
The good news is that improving your debt-to-income ratio is possible — and almost entirely under your control. But it might take time. “Two obvious steps to (improving) your debt-to-income ratio would be either increasing your income or decreasing your debts,” Henderson says.
Paying off your debt is the best way to lower your DTI. After all, the less debt you have, the greater the gap between your debts and your income. “Focus on reducing your outstanding debts, starting with high-interest obligations like credit card debt,” Sergunina says.
Regularly making payments above the minimum can accelerate your debt reduction, she adds. Then, try to avoid opening new lines of credit.
Boosting your income can also lower your DTI. A raise at your current job, a new job with a higher salary, or even a part-time job or side hustle can increase the money coming into your household.
Why DTI Is Important
Lenders want to be confident that their money will be paid back, and DTI shows how much of your income goes toward paying down debt and how likely it is that you will pay back your obligation. Borrowers with lower DTIs are more likely to be approved for a loan. They also may be able to access larger loans and to borrow money at the lowest interest rates.
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What Is a Good DTI for a Mortgage? originally appeared on usnews.com
