Your debt-to-income ratio is not only important for your personal financial management, it also plays a role in the loan approval process. Knowing how to calculate your debt-to-income ratio (DTI) can help you improve your finance management.
While debt-to-income ratios are just one tool used in mortgage determination, they’re a pretty big factor in determining your qualification for a loan. Before we can learn how to calculate and improve our DTI, we first need to understand what a Debt-to-Income ratio is.
What is a Debt-to-Income (DTI) Ratio?
A debt-to-income ratio is an indicator of a person’s overall financial health. A DTI ratio divides you monthly debt payments by your monthly gross income. Lenders use this ratio to determine if you can afford to pay back the loan.
A higher DTI ratio shows that the borrow is more a risk for the lender.
There are two factors mortgage lenders use for a debt-to-income ratio.
The front-end ratio – aka the housing ratio, is the dollar amount of all your home-related expenses (your future monthly mortgage payment, insurance, property taxes, etc.) divided by your monthly gross income.
The back-end ratio – includes all other monthly debt (personal loans, credit cards, car loans, etc.) plus your mortgage and other home-related expenses.
The back-end ratio holds more weight but mortgage lenders will look at both factors for a conventional loan. They typically look for a front-end DTI that is below 28% and a back-end DTI that is below 36%. For FHA loans (government-backed loans), lenders may consider higher DTIs up to 50% for back-end ratios.
What’s the 43% Rule?
The 43% rule is the pivotal point and deciding number of who qualifies for a loan. The standard for qualifying for a home loan is 43% for loans through the Federal Housing Authority and VA. Conventional home loans prefer the DTI be closer to 36% to ensure you can afford the payments. If your monthly debt payments exceed 43%, it’s unlikely you will qualify for a loan.
The 43% rule is vital for homebuyers to keep in mind because that is the absolute highest ratio they can have to get qualified for a mortgage – and that still depends on the lender!
How to Calculate your Debt-to-Income Ratio?
Calculating your DTI ratio is easy, just follow these 3 simple steps:
Add all our current debts by knowing how much debt you owe and adding up your monthly bills. This includes:
- Credit card bills
- House mortgage
- Student loans
- Car loans
- Business loans
- Any other debts you pay on a monthly basis
Exclude your daily expenses like food, transportation, utilities, and taxes because these are not considered debt.
Determine your gross monthly income (the amount earned before taxes and other deductions)
Calculate your debt-to-income ratio by dividing your debt with your income. For example if your debt was $200 and your income was $1,000 then your debt-to-income ratio is 20%.
The debt-to-income ratio formula looks like this:
(Total of your monthly debt payments) / (Gross monthly income) = (Debt/Income) * 100 = debt-to-income %
If you want to make things even easier, try our DTI ratio calculator.
How to Improve your Debt-to-Income Ratio
A better ratio improves your loan rates. The best way to improve your ratio is to pay off your debts before you begin applying for loans. Another option is to increase your income.
It will take dedication, a budget, savings, and intentional spending to lower your debt-to-income ratio at a faster rate, but it is possible. It’s vital to know how much money you earn each month compared to how much you spend.
If you’re living life by making minimum payments on your debt, then it’s time to start making larger payments to lower your balances. That means cutting spending and/or making more money. You can also look into debt consolidation options.
Other ways to lower your debt-to-income ratio are to avoid taking on any more debt and avoid making any big purchases on credit.
DTI Ratio and Credit Score
It’s important to know what lenders consider when applying for a loan. A few factors that affect your loan are your credit score, credit reports, and your DTI.
While DTI does not directly affect your credit score, the amount of debt you have does affect your credit. As well as the age of loans you have, the mixed types of credit you’re using, how consistently you’ve paid debts over time, and how many recent hard inquiries are on your credit report.
What is a Good DTI Ratio to Get Approved for a Mortgage?
Lenders prefer to see a debt-to-income ratio less than 36%, with no more than 28% of that debt going towards servicing your mortgage.
One of the most important things to remember is that all lenders are not created equal. When it comes to pricing, there are many dishonest lenders. It’s critical to find someone you can trust and who is dedicated to saving you money and providing you knowledge along the way.
If you are preparing to get approved for a mortgage, Loan Compass can help. We specialize in mortgage loans, finding you the best rate possible. To find out what type of loan you can get with your current DTI ratio, speak with an expert!