Key takeaways
- Your debt-to-income ratio (DTI) helps lenders determine if you can afford to take on additional debt, such as a mortgage loan.
- If your DTI is too high, you may not be approved for a loan, or you may not receive the best interest rates.
- You may lower your DTI by paying off existing debt, increasing your income or purchasing a lower-priced home.
When you're looking for a new home, you're likely taking a crash course in new mortgage and finance terms. Debt-to-income ratio, which compares your monthly debt payments to your income, is a common one. Lenders assess yourdebt-to-income ratio for a mortgageto evaluate your financial ability to take on a new loan.
What is a debt-to-income ratio?
A debt-to-income ratio compares your monthly debt payments to the amount of income you generate. When you apply for a mortgage, a lender may ask you to list your current debt and income on the application.
The lender will use those amounts to calculate your DTI. This ratio helps determine if you can handle the anticipated mortgage payment while still keeping up with other monthly payments. While reviewing your debt-to-income ratio for a mortgage is common, lenders may also consider this ratio when approving an auto loan, new credit card or personal loan.
Why is DTI important?
Lenders take your DTI into account when deciding if you can afford to purchase a home. If your DTI exceeds their preset guidelines, you may not be approved for a mortgage. Getting preapproved for a mortgagecan help you set a homebuying budget and ensure you feel comfortable when making an offer to a seller.
Leverage your existing banking relationships when seeking a new loan. If you have a savings or checking account, stop by your local branch and ask about mortgage programs for existing bank customers.
How to calculate your debt-to-income ratio
You might find it helpful to know your debt-to-income percentage before you apply for a loan. To further evaluate your financial position, lenders may calculate two different ratios, known as HTI or housing to income ratio and back-end DTI:
- The housing to income ratio equals the sum of your monthly housing payment, divided by current income.
- The back-end DTI consists of your monthly housing payment plus all other monthly debt, such as your car payment or credit card balance.
Here's how to calculate your DTI:
1. List your monthly debt payments
Make a list of every outstanding loan and the amount you must pay each month. Student loans and car loans count as debt. So do credit cards, even if you always pay the balance in full. You may notice slight variations between different lenders' calculations of DTI, but generally, these amounts are considered debt:
- Monthly housing costs, including a mortgage, insurance, homeowners’ association fees and property taxes
- Rent payments
- Home equity loans or lines of credit
- Student loans
- Credit card debt balances
- Pay now pay later loans
- Auto loans
- Personal loans or lines of credit
- Child support
- Alimony
You don't need to include amounts such as:
- Utility payments
- Household expenses such as groceries, gas and entertainment
- Health or car insurance
Before you finalize the debt portion of your DTI, you may want to request a free credit report to avoid missing any outstanding balances. If you're the cosigner or the co-borrower on a loan, the outstanding amount owed may also affect your debt-to-income calculation, even if you don't make the monthly payments.
2. Calculate your monthly income
Use your gross monthly income — your total income before taxes and other deductions — when calculating your debt-to-income ratio.
3. Divide your debt payments by your income
Divide your monthly debt payments (step 1) by your monthly gross income (step 2). To calculate your front-end DTI, use only your monthly housing payment amounts. For a back-end DTI, include all types of debt. Lenders may also use your new mortgage payment in these calculations to make sure you meet their approval guidelines.
What's a good debt-to-income ratio?
- Ideally, your front-end HTI calculation should not exceed 28% when applying for a new loan, such as a mortgage.
- You should strive to keep your back-end DTI ratio at or below 36%.
Staying within these ranges demonstrates to the lender that you are well equipped to meet your ongoing financial obligations while still leaving room in your budget for living expenses and unexpected events. If you’re applying for something new such as a car loan or a credit card, it helps to understand what's considered the ideal debt-to-income ratio.
While you may be approved for a mortgage or other type of loan with a back-end DTI higher than 36%, the lender may not offer you the best interest rates and terms. First-time buyers or others who don't meet the 36% target may want to ask their lender about government-backed mortgages, such as an FHA loan, with higher DTI thresholds.
Plan how to improve your DTI. If you'd like to buy a home in the next year, take steps to start paying down your debt today. Consider the timing of other large purchases, such as a new car, that may affect your DTI.
How to lower your DTI
If your DTI exceeds the lender's guidelines, you can take steps to bring the percentage down to an acceptable range. You can lower your debt-to-income ratio in three ways: increase your income, pay down your debt or consider purchasing a less expensive home with a lower mortgage payment.
Ways to increase your income:
- If available, request overtime hours at work.
- If appropriate,ask for a salary increase.
- Look for a side hustle.
- Consider getting a part-time job.
Ways to pay down your debt:
- Pay down high-interest debt with thewaterfall method.
- Consider abalance transfer credit card.
- Look intorefinancing student loans.
- Decrease your monthly savings andprioritize debt payments for a short time.
- Cut back on discretionary expenses, such as restaurant meals, and use the money saved topay off credit cardsor other loans.
