If you consider three to be a lucky number, then you’re in luck. Why? Because there are three key factors that play a role in determining your eligibility for a mortgage. You’re likely familiar with the first two – income and credit history – because these are the two that most often come to people’s minds. The third is debt-to-income ratio (DTI), which you might not be as familiar with.
No less important than income or your credit score (and not to be confused with your credit utilization ratio, which is a measure of how much of your available credit you’re actually using), DTI can significantly affect your ability to qualify for mortgage, which is why it’s necessary to fully understand it. Let’s jump right into it.
What is Debt-to-Income Ratio?
The debt-to-income ratio (DTI) is a critical metric that underwriters look at when determining your borrowing ability. Simply put, DTI is the amount of debt you have compared to your overall income. It’s reflected as a percentage and calculated by dividing monthly debt payments by gross monthly income. A DTI of 43% is generally accepted as the highest percentage a borrower can have and still qualify for a mortgage, though some lenders and loan programs may accept higher ratios even up to 50%. Many consider 36% or less to be a “excellent” DTI. Essentially, a low DTI ratio shows lenders that you have a favorable margin between debt and income. Not to worry, though. If you have a high DTI ratio, we’ll give you some pointers on how to lower it.
Does my DTI affect the type of loan I can get or my interest rate?
Just as different lenders can have different DTI requirements, different loan types do as well. DTI requirements vary according to loan type (such as Conventional, FHA, VA or USDA loans), so your specific DTI may affect the type of mortgage loan you’re eligible to get. Your lender can guide you through their DTI thresholds for both conforming and non-conforming loans. (Side note: conforming loans must meet the funding criteria of Government-Sponsored Enterprises such as Fannie Mae or Freddie Mac, while non-conforming loans don’t conform to these requirements. Jumbo loans are examples of non-conforming loans.) Your DTI ratio can also directly impact your interest rate; a lower DTI presents you as a lower-risk borrower and can thus help you secure a lower rate on fixed and adjustable rate loans.
Two main types of DTI
There are two main kinds of DTI that lenders evaluate, and they’re often expressed together: front-end and back-end. The front-end ratio looks at your monthly income that goes towards housing costs (principal and interest, mortgage insurance, property taxes and homeowners’ association dues). Most lenders look for front-end ratios that are less than 28%. The back-end ratio looks at your monthly income that goes towards paying recurring debts, including the housing costs covered in the front-end, plus credit card payments, car payments, student loans, child support, alimony, etc. Most lenders look for back-end ratios that are less than 36%. Both ratios are important, but the back-end ratio may carry more weight with lenders because it more fully reflects your monthly liabilities debt payments versus your monthly income.
How to Calculate
Want to calculate your DTI ratio yourself before you apply for a mortgage? No problem. As we stated, DTI is determined by your monthly debt payments divided by your gross monthly income. To break it down even more clearly:
1. Add up your monthly debt payments. These may include:
- Current house payment or monthly rent
- Student loan debt
- Car loans
- Outstanding credit card debt
- Other monthly bills, including alimony or child support, but excluding including groceries, gas, entertainment, etc.
2. Add up your gross monthly income. Sources of verifiable income can include:
- Your employment salary or wages
- Investment income
- Secondary income such as a part-time job or side hustle
- Bonuses and commissions
- Pension or Social Security
- Alimony, spousal support and child support
3. Divide #1 (monthly debt payments) by #2 (gross monthly income) and convert to a percentage to get your DTI.
For example, if your total monthly debt payments are $2,000 and your gross monthly income is $5,000, then your DTI score would be 40% ($2,000 / $5,000 = 0.40 = 40%)
Another real-world scenario is as follows: If your monthly gross income is $4,000 and your monthly debt payments are $825 (i.e., $350 car payment + $200 personal loan + $275 student loan), then your DTI score would be 21% ($825 / $4,000 = 0.206 = 21%).
I Have a High DTI Score. How Can I Lower It?
Since one of the keys to unlocking the door of homeownership is reducing your DTI, we want to provide you with easy steps you can take to actively lower it.
Increase your income
– This might mean working some overtime, asking for a salary increase or taking on a part-time job. Be advised, though, that income verification standards have increased greatly in the modern lending (and as a result of the 2008 financial crisis) so be mindful that cash or otherwise non-reported earnings will likely not count toward your “income,” although it could be used to reduce or payoff outstanding debts and have the same impact on the DTI score (less debt is good!)
– Review your bank and credit card statements to see where you are spending most of your money. Cut back on unnecessary expenses and research other providers of insurance, phone, cable and other utilities to see if there are lower-cost alternatives. Take those savings and apply them to reducing the debt that is calculated in your DTI ratio, such as credit card balances and other loan debt.
– A high DTI is not necessarily bad if you’re actively reducing debt. For example, if your income is $2000 per month and you’re putting $1000 towards debts, your DTI is temporarily 50%, but will be reduced to 0% when you’ve fully paid off outstanding debt balances. If you have any cash saved, you might want to consider paying off some debt.
If you’re able, try and completely pay off an outstanding debt, even if it’s just the smallest of all your debts. If you plan on this approach, ask the creditor the date they report to the credit bureaus, then after your account has been updated, it will show less outstanding debt when lenders evaluate your credit history, liabilities and DTI ratio. You can also track changes to your credit report with free services like https://www.annualcreditreport.com/.
You can also consolidate your debt by taking out a home equity loan or even a personal loan. Obviously, you’ll want to obtain a lower interest rate than what you’re paying on your current debt as part of a smart debt consolidation strategy. And you’ll want to avoid adding any new debt, so don’t take out any new credit cards, even if you don’t plan on using them.
Finally, if you’re looking to refinance but have a higher DTI (up to 65%), Fannie Mae and Freddie Mac have launched programs to help borrowers like you. AmeriSave is currently participating in the new refinance option through Fannie Mae.
We just threw a lot of information at you. Luckily, AmeriSave is here to help you with questions about not only your DTI but also regarding your income and credit history, the other two factors we mentioned at the beginning. (And in case you’re wondering, your DTI doesn’t impact your credit score.) Contact us to talk through DTI or any other step within the mortgage process; our loan originators partner with homeowners every day to help them successfully reach their homeownership goals.