Do you know your debt-to-income (DTI) ratio? If you’re getting ready to apply for a mortgage, it could come in handy. Lenders use your DTI ratio to assess how credit-worthy you are, so familiarizing yourself with it can help you prepare your finances for the lending process.
What is the debt-to-income ratio?
The debt-to-income ratio compares the amount of debt you have with your overall income. Lenders usually couple your DTI ratio with your credit score determine how much money you can afford to borrow. A high DTI ratio signals to lenders that you cannot afford to make monthly payments, as your debt takes up a significant portion of your monthly income. When you’re applying for a mortgage, the lower your DTI, the better.
Calculating the Ratio
Computing your debt-to-income ratio is simple:
Total Monthly Recurring Debt
Gross Monthly Income
If you make a high amount of income or have a small amount of debt, you will have a lower ratio. If the opposite is true, your DTI will be high. Calculating your debt-to-income ratio before applying for a mortgage loan will help you know whether your lender will be willing to let you borrow—it can even help you determine if you’re financially ready to borrow.
The Two Types of DTI
Front-end DTI considers only your housing costs, such as a mortgage payment, rent payment, or mortgage insurance. If you make $5,000 a month, and you have a monthly mortgage payment of $1,250, your front-end DTI ratio is 25 percent. Even if you have other monthly debt obligations, like a car payment or a student loan, your front-end DTI will remain the same, as it only accounts for housing costs.
Back-End DTI takes all of your recurring debt payments into consideration. If we use the above example, and you have an additional $750 in monthly debt payments, your back-end DTI is 40 percent. This number dwarfs your 25 percent front-end DTI. When you calculate your debt-to-income ratio, bear both of these ratios in mind. Your lender might use either one to assess your ability to make monthly mortgage payments.
The 43 Percent Rule
In most cases, a 43 percent debt-to-income ratio is the limit for borrowing and getting a Qualified Mortgage (exceptions are sometimes made for smaller lenders). Qualified Mortgages have features that make sure you can actually afford your loan. The 43 Percent Rule is the hard ceiling, but experts recommend that you keep your ratio lower than 36 percent, with a front-end DTI of no more than 28 percent. To bring your ratio down to these levels, you have two options: bring in more income or pay off debt. Either one will tip the scales in your favor. Now that you know what your debt-to-income ratio is, how to calculate it, and the difference between front-end and back-end DTI, you are equipped to prepare yourself for a loan application. Recognizing lenders’ debt-to-income parameters—and understanding what lowers your ratio—will empower you to optimize your finances and qualify for a loan.
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Sources Consumer Financial Protection Bureau Investopedia Bankrate