Understanding the Debt-to-Income ratio: what it is and why it matters
When you begin the homebuying process and apply for a home loan, you will encounter a term known as debt-to-income ratio. Debt-to-income ratio, or DTI, is the sum of all your monthly debt obligations divided by your gross monthly income. This is your income before taxes and any other deductions. DTI is an important number used to qualify you for a mortgage and can be uncovered during the pre-approval process. Different loan programs have different requirements, so knowing this number is critical before applying for a home loan.
What is the Debt-to-Income ratio?
The formula to calculate your DTI is as follows:
DTI=Total Monthly Debt Payments/Gross Monthly Income x 100
For example, if your monthly debt is $1800 for your housing payment, $300 for an auto loan, and an additional $400 for other monthly debt payments, your monthly debt is $2,500. If your gross monthly income is $6,000, your DTI equals 41%.
When calculating the DTI, keep in mind that monthly bills such as utilities, groceries, insurance premiums, healthcare expenses, and daycare are not included.
What is the difference between front-end and back-end DTI ratios?
As you navigate the underwriting phase of your mortgage application journey, you may hear terms like front-end ratio and back-end ratio. They are distinctly different.
The front-end ratio, also called the housing ratio, shows what percentage of your monthly gross income would go toward your housing expenses, including your monthly mortgage payment, property taxes, homeowners’ insurance, and homeowners’ association dues.
The back-end ratio shows what portion of your income is needed to cover all your monthly debt obligations, plus your mortgage payments and housing expenses. This includes credit card bills, car loans, child support, student loans, and any other revolving debt that shows on your credit report.
Why is the DTI ratio important?
The DTI ratio is important to determine whether you can comfortably pay for your new mortgage given your current debt and income. Lenders like Mortgage Equity Partners typically look for a front-end ratio of no higher than 28% and a back-end ratio of no higher than 36%, but higher ratios may be accepted depending on the loan type and other factors, such as additional assets and savings.
Remember that while you may qualify for a particular loan amount based on a preliminary examination of your income and assets, the DTI calculation determines whether you can make the monthly payment while still meeting all your other financial obligations. We want you to be able to afford your new payment and still have money left over to live comfortably.
Tips for improving your DTI ratio
Lowering your DTI can positively impact your financial life in several ways. First, it will relieve stress since you will have less debt. Reducing debt may improve your credit score and lower your DTI, which makes the loan approval process easier. Here are some reliable methods to lower your DTI:
1. Create a budget
Review your spending habits and create a budget. This will help you recognize where your money is going and reallocate funds to pay down your debt.
2. Deal with debt
Decide to pay down your current debt and create a plan.
3. Reduce interest rates
Look for ways to reduce interest rates if you carry high balances on your credit card/s.
4. Additional debt
Do not take on additional debt or apply for more credit while applying for a home loan. This will drive up your DTI and impact your credit score, which could ultimately affect your loan approval.
Applying for a mortgage involves many terms that may be new to you. Working with an experienced local lender who can spend time reviewing your application and educating you on the key terms will make the process less stressful. Feel free to use the formula above to run your DTI and contact one of our knowledgeable loan officers to ensure you are on track.
