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Next to your credit score, your debt-to-income ratio (DTI) is the next largest factor when applying for a mortgage.
A high DTI could mean you don’t get approved, or if you do, it’s at much higher interest rates. A low DTI could get you the best loan terms and the lowest rates.
Here’s everything you must know about the debt-to-income ratio.
What is Debt-to-Income (DTI) Ratio?
Your debt-to-income ratio compares your total monthly debts to your gross monthly income (income before taxes).
Mortgage Lenders use these numbers to determine how likely you are to default on the mortgage.
The more money you have committed each month, the harder it is to pay your bills on time if you have any type of emergency or even spend too much on ‘other costs.’
Lenders look at two types of DTIs:
The front-end DTI or housing debt ratio compares the total housing payment to your gross monthly income.
Your housing payment includes the principal, interest, monthly real estate taxes, monthly homeowner’s insurance, HOA dues, and any mortgage insurance you pay.
Most lenders like the front-end DTI to be between 28% – 31% at the most, as this leaves room for other debts you’re likely to have.
The back-end DTI or total DTI compares all your monthly debts, including the new mortgage. It includes any debts reported on your credit report, such as minimum credit card payments, installment loans, personal loans, and student loans.
Each loan program is different, but most lenders prefer that your back-end DTI doesn’t exceed 43% – 50%.
Which Debt-to-Income Ratio Do Mortgage Lenders Prefer to Use?
While lenders look at your front-end ratio, it’s the back-end DTI that really helps them determine if you qualify for the loan.
The total DTI tells lenders how much of your income you must spend each month to meet your obligations. If it’s too high, you could have a higher risk of default.
Understanding Debt-to-Income (DTI) Ratio in the Mortgage Process
Your DTI is just one factor lenders consider when looking at your loan application.
Like your credit score, it’s something you can check on before you apply, so you know where you’ll stand. If your DTI is too high, it’s a good idea to lower it before applying for a loan.
How Debt-to-Income Is Calculated
Fortunately, you can calculate your DTI, both front, and back-end, before applying for a mortgage loan. Here’s how.
- Front-end ratio – Total the new mortgage payment, including the principal, interest, real estate taxes, homeowner’s insurance, mortgage insurance, and HOA dues, and divide it by your gross monthly income.
- Back-end ratio – Take the total mortgage payment from above and add it to any of your monthly costs, including minimum credit card payments, installment loans, personal loans, and student loans. Divide the total by your gross monthly income. (Don’t include the daily cost of living fees, utilities, insurance costs, or any costs not reported on your credit report).
Debt-to-Income Ratio Example
Here’s how the DTI works.
Your income before taxes is $10,000 a month. You’re trying to get a mortgage with a principal and interest payment of $1,500. The real estate taxes are $5,000 per year, and the homeowner’s insurance is $1,200 annually. The HOA dues are $50 a month, and you don’t have to pay mortgage insurance.
You also have the following debts:
- Credit card payments $100
- Car loan $350
- Installment loan $150
Your front-end DTI would be:
$1,500 + $416.67 + $100 = $2,016.67/$10,000 = 20.2%
Your back-end DTI would be:
$2,016.67 + 100 + 350 + 150 = $2,616.67/$10,000 = 26%
What Is a Good Debt-to-Income Ratio to Get a Mortgage?
A good debt-to-income ratio is subjective, just like a good credit score. Each loan program has different requirements.
The exact DTI requirements vary by lender for conventional loans, but your DTI should be less than 50% on average. The lower your DTI is, the easier it is to qualify for a loan.
USDA loans have strict DTI requirements on both the front and back end. On the front-end, your DTI can’t exceed 31% and, on the back-end, 41%.
This is because USDA loans are for low to moderate-income families, so the USDA doesn’t want you to stretch yourself thin.
FHA loans have more flexible DTI requirements, but they prefer a back-end DTI of no more than 50% like conventional loans.
They look at the big picture, including your credit score and income stability. The higher your credit score is, the more lenient they can be with your DTI.
VA Home Loans don’t focus on your debt ratio. Instead, they look at your disposable income or money you have left after you pay your bills.
The VA has a specific amount of disposable income for each area and family size. They would much prefer you meet those requirements than focus on a DTI.
Jumbo loans are loans for more than $548,250. Because of the higher risk lenders take with these often limit the DTI to much lower limits.
They want to know that you can easily afford the higher loan amount and won’t get bombarded with a ton of other loan payments that might make it hard to pay your mortgage. Some lenders will go up to 50%, but most want a lower DTI.
How Can I Lower My Debt-to-Income Ratio?
Like your credit score, you can adjust your DTI before you even apply for a mortgage. Here’s how.
Pay Off Outstanding Debts
Pay off your existing debts. If you have money for a down payment that exceeds the minimum amount required, consider using it to pay off your debts rather than investing it in your home. With a lower DTI, you’ll get a better rate and have a better chance at securing a better loan.
If you’re eligible for a raise soon, wait for it before applying for a mortgage. A higher-income can decrease your DTI and increase your chance of approval.
Don’t use your credit cards. You can have credit card debt and still get a mortgage, but the more debt you have, the higher your minimum payment becomes. This increases your debt-to-income ratio and makes it harder to get approved.
>> More: How to Choose the Best Mortgage
What If My Debt-to-Income Ratio is High?
If your DTI is high, you may still get a mortgage. Online Mortgage Lenders look at the big picture, which means if you have any compensating factors to make up for a high DTI, you may still qualify.
What counts as a compensating factor?
It varies by lender, but any of these may count:
- High credit score
- Higher than necessary down payment
- Increasing income
- Liquid savings on hand that you aren’t using for a down payment or closing costs
Bottom Line: What Is Debt-to-Income Ratio?
Your debt-to-income ratio is an important factor when applying for a mortgage. Try decreasing your debts as much as possible, increasing your income, and avoid overspending so you can qualify for a mortgage with a low DTI and get the best terms.