Mortgage rates are the lowest they’ve been in quite some time. If you’re looking to buy your first home, move from your existing home into a new home or refinance your current loan, you’ve probably been paying close attention to mortgage rates.
One of the critical components of your ability to be approved for the best interest rates is your debt to income ratio. Lenders use this metric to determine whether you’re eligible for a mortgage and, if so, the type of rate you should receive.
In this article, we’re here to cover everything you need to know about the debt to income ratio for mortgages. We go over what it is and why it’s important. We also go over what the ideal debt to income ratio should be and the things you can do if you have a high ratio. By the end of this article, you should have a much clearer understanding of what you need to do to secure the best rate from mortgage lenders.
The debt to income ratio (DTI ratio) is a measure of how much debt you currently carry compared to how much you earn. It represents, in percentage form, how much of your gross monthly income goes toward payments for your:
- Housing expenses (rent/mortgage)
- Monthly minimum credit card payments (unless you routinely pay more than the minimum)
- Alimony or child support payments
- Medical bills
- Student loan payments
- Auto loans (car payments)
- Personal loans and other forms of lending
To calculate your DTI ratio, you need to know how much you make per month as well as your total monthly debt payments. When calculating your gross income, be sure to use the pre-tax number. You can find this number on your paystub.
For instance, you may take home $952 per week in net income after taxes. After looking at your pay stub, you realize that you make $1,300 per week. If you multiply this number by 52 — the number of weeks in a year — your gross annual earnings come out to $67,600. Divide this number by 12 to determine your monthly income. In this case, the number is $5,633.33 per month.
Next, figure out your monthly expenses.
When it comes to credit cards, you should include at least your minimum amounts, since paying these regularly is the recommended practice. However, if you routinely pay more than the minimum each month, you should include that figure instead.
Note that the figures you are tallying are only your monthly debt obligations. It does not include things like utilities, gas and taxes. If you happen to put these expenses on a credit card, they will be reflected in your monthly minimum credit card payments.
Once you’ve added up your monthly expenses, divide your total expenses by your gross monthly income. In our example, the monthly earnings were $5,633.33. Let’s say that your monthly debt obligations are $3,000 per month.
When you divide $3,000 by $5,633.33, you get .5325. Multiply this by 100 to turn it into a percentage — this is your DTI ratio. In this example, your DTI ratio is 53.25%. This shows lenders that more than half of your income goes toward debt.
Lenders have a responsibility to determine how likely you are to repay borrowed money. One of the most common ways of doing this is by looking at credit scores. A credit score is a three-digit number that is reflective of the information contained in your credit report. But, lenders can use other means to determine your potential eligibility.
Measuring your DTI ratio is one of the other most popular ways that lenders can measure your ability to repay borrowed money. Your DTI ratio is representative of your personal finances, as it shows how healthy they are and how much cash you have on hand. Generally speaking, the lower your DTI ratio, the better you look in the eyes of lenders.
If you are a first-time homebuyer, there’s a strong chance that the amount of debt you’re about to take on is the largest amount you’ll have ever borrowed. Lenders have a few different ways of measuring your ability to make monthly mortgage payments.
For instance, the front-end ratio is a DTI ratio that predicts how much debt you’ll take on in the future if you are approved for your mortgage. The front-end DTI ratio only includes your monthly expenses from:
- Future monthly mortgage payment
- Property taxes
- Homeowner’s insurance
- Homeowner’s association dues
Whereas the front-end ratio exclusively looks at housing costs, the back-end ratio represents all of your debt. So, the back-end DTI is all of your monthly debt obligations in addition to anything associated with housing costs. By comparing the difference between the front-end and back-end ratios, lenders can easily measure the impact a mortgage loan would have on your personal finances and how much debt is tied up in non-homeownership expenses.
When qualifying you for a home loan, lenders have maximum DTI parameters that they tend to stick to. This is especially the case if you are receiving an FHA loan. An FHA loan is backed by the Federal Housing Administration. The FHA requires that the front-end DTI of borrowers be no more than 31% and the back-end be no higher than 43%.
If you are submitting a mortgage application through a private lender, you may have a bit more flexibility in these requirements. This is especially the case if you have good credit. But, if you have a high DTI, home buying becomes more challenging.
If you have a high debt-to-income ratio, there are a couple of things you can do. Broadly speaking, you need to reduce the amount of debt that you have.
From a home-buying perspective, you can invest more in home equity. If possible, put down a higher down payment. This will lower the total amount of your mortgage, therefore reducing how much you have to borrow and how much debt you need to take on.
You can also focus on paying down your existing debt to lower your back-end ratio. You can use tools like debt consolidation and refinancing to lower your interest rates and accelerate how quickly you can pay down existing debt.
If you want to reduce your DTI ratio by lowering your credit card debt, you can consider using the Tally app. Tally helps you pay down your existing credit card balances in the most efficient way possible.
Though DTI plays a big role in the mortgage approval process, it’s not the only factor. As mentioned, your credit score is one of the biggest influences on whether you’re approved.
Your down payment also plays a significant role. Putting down a larger down payment can lower your DTI. But, at a minimum, you should aim to put down 20% of your home’s purchase price. This means that your mortgage represents 80% of your home’s equity. If you put down less than 20%, you will typically have to carry PMI insurance until the principal balance of your mortgage is below 80% of the home’s original value. Most lenders require at least 5% down, though some will go as low as 3% if you’re a qualified borrower.
Entering the real estate market for the first time can be daunting. Before doing so, it’s important that you have your finances in order. After checking your credit report, you can look into determining your DTI ratio.
The DTI ratio measures how much of your income goes toward debt. The lower the DTI, the more likely lenders are to approve you for a mortgage. Understanding your DTI allows you to better determine the maximum amount that you can spend on a home.
If you have a high DTI, there are some things that you can do to lower it. Focus on reducing your overall debt. You can either put down a larger down payment or reduce your back-end debt by using a tool like Tally, which can help you pay down your current credit card balances.