Buying a home is expensive, but a good debt ratio can reduce costs by giving you access to the best mortgage interest rates.
Your DTI ratio helps lenders determine the level of risk you pose as a borrower. A high ratio could signal high risk for the lender and equate to high interest for the borrower.
Find out how a DTI ratio is calculated and which ratios are most likely to help you get the mortgage you want.
How is the debt to income ratio calculated?
Calculating your DTI ratio is simple: add up your monthly bills and divide that number by your gross monthly income, or your salary before taxes or other deductions.
Let’s say you spend $1,200 on rent, $500 on a credit card bill, and $150 on a car loan, or $1,850 total in monthly debt payments. Your gross monthly income is $5,000. Divide your monthly debts ($1,850) by your gross monthly income ($5,000) and the result is a DTI ratio of 0.37, or 37%.
Front/back-end DTI ratios
Front end DTI report. This ratio focuses strictly on how much of your gross income goes towards housing costs. You can calculate it by adding up your monthly housing expenses, such as mortgage and insurance payments, dividing the total by your gross monthly income, and multiplying the result by 100.
If your housing expenses are $1,000 and your gross monthly income is $3,000, your initial DTI would be 33% ($1,000/$3,000 = 0.33; 0.33×100 = 33.33 %).
The initial ratio best indicates the income the borrower is putting towards the mortgage, “which has a huge impact on their ability to repay” on time, says Jamie Cavanaugh, chief operating officer of Amerifund Home Loans, Simi Valley, California.
Debt to final income ratio. This ratio represents the portion of your gross monthly income that is allocated to paying debts, including credit cards, car loans, and housing payments. Total your monthly debts, divide the sum by your gross monthly income, then multiply the result by 100 for your primary DTI ratio.
Lenders evaluate entry and exit ratios when deciding whether or not to approve a loan. “Even if a borrower’s original housing ratio is low, their total debt-to-income ratio may be so high that they would struggle to manage their new mortgage payment,” Cavanaugh said.
The final ratio is more important than the initial ratio on your loan application, says Brendan McKay, owner and senior loan officer at McKay Mortgage Co., Bethesda, Maryland.
“The majority of programs put little emphasis on front-end DTI, and to some extent that makes sense,” says McKay. “Someone’s budget is their budget. Whether a dollar of that budget is spent on a mortgage or paying for a car, their bank account is exactly the same.”
Why is the debt to income ratio important?
Having a high DTI ratio is essential to qualify for a home loan on the best terms. Studies have shown that people who have higher DTI ratios are more likely to have difficulty with payments, according to the Consumer Financial Protection Bureau.
If your DTI ratio exceeds 43%, according to the CFPB, you may not be able to get a qualifying mortgage. A qualifying mortgage follows certain guidelines put in place to prevent lenders from making loans that borrowers cannot afford to repay.
What is the relationship between the debt ratio and my credit score?
Your DTI ratio has no effect on your credit score or credit report. Yes, someone with high debt can have a high DTI ratio and a bad credit score, but the two have no direct relationship, according to the Equifax credit bureau.
Credit score models often consider a different ratio – your credit utilization rate – when calculating your credit score.
Of course, a good credit rating is crucial to qualifying for a mortgage at the best possible rate. A reputable credit repair company can help if you’re struggling to prepare your credit score to buy a home, Cavanaugh says.
How can I improve my debt ratio?
There are two ways you can try to improve your DTI ratio, though they’re deceptively simple: “Earn more money or pay off debt,” says McKay.
If you hope to achieve both, Equifax suggests asking yourself these questions:
- Can you pay off a car loan or a credit card?
- Can you get a debt consolidation loan to lower your monthly credit card payments?
- Did you omit any income from your loan application, such as money from a side business or a second job? The extra money improves your ability to pay off a mortgage.
- Can you negotiate a raise or work overtime? You may want to put your loan application on hold if an increase is coming.
Before paying off debt, talk to your mortgage broker, McKay says. Sometimes what’s good for your DTI ratio may not be good for your overall financial health.
“Make sure you have to follow these steps first,” he says. “Many people go to mortgage brokers thinking they have to pay more than they make to qualify.”
What is the ideal DTI ratio?
The ideal DTI ratio is: “The lower the better,” says McKay. His rule of thumb is that most people are comfortable with a DTI of 35% or less.
Many lenders prefer to see DTI ratios no higher than 36%, according to credit bureau Experian.
Meanwhile, Fannie Mae says that for manually originated loans, the maximum total DTI ratio for mortgages is 36% of the borrower’s “stable monthly income”. However, the maximum may exceed up to 45% for borrowers who meet specific credit score and cash reserve requirements and reach 50% in other circumstances.
Even if your DTI ratio is trending up, this number won’t necessarily derail your attempts to qualify for a loan.
“Many factors go into evaluating a loan application for approval,” Cavanaugh said, adding that metrics such as credit score or money in the bank “can have a big impact on acceptance of higher debt ratios”.
McKay admits there is some obscurity as to the precise value of your DTI ratio to secure a mortgage. Sometimes the final yes or no decision on your loan can be made by a computer.
“Decisions in many gray area situations are determined by automated underwriting systems that weigh many factors,” he says.