When you start the journey of buying a home, it's common to seek out online resources for initial guidance. You might wonder what information you'll need to provide to a lender or mortgage broker during the homebuying process. One crucial aspect lenders focus on is your debt-to-income (DTI) ratio.
What is the Debt-to-Income (DTI) Ratio?
The DTI ratio measures the proportion of your monthly debt payments compared to your gross monthly income. Lenders use this ratio to assess if you're carrying too much debt, which could indicate a higher risk of defaulting on your mortgage.
In this guide, I'll explain how to calculate your DTI ratio, provide examples, and offer strategies to improve it.
How to Calculate Your Debt-to-Income (DTI) Ratio
Calculating your DTI ratio is straightforward. Start by adding up your fixed monthly expenses, such as:
- Rent or mortgage payment
- Property taxes and homeowners insurance (if not included in your mortgage)
- Homeowners association dues
- Alimony
- Child support payments
- Student loan payments
- Auto loans
- Personal loans
- Fixed and variable credit card payments
Exclude variable expenses like groceries, utilities, gas, and travel.
Use the following formula to calculate your DTI ratio:
Monthly Bills
÷
Gross Monthly Income
=
DTI Ratio
Include all sources of income, such as wages, salary, pension, Social Security, child support, alimony, and side hustle earnings (only can be used in certain circumstances).
Example Calculation:
- Monthly debts: Rent ($1,500), Student loans ($1,000), Personal loan ($500)
- Gross monthly income: $7,000
- 3000/7000 = 0.4285
Multiply by 100 to get a percentage: 0.4285 × 100 = 42.85%
Types of DTI Ratios
Lenders consider two types of DTI ratios:
- Front-end DTI Ratio: Includes only housing-related expenses, like your future (proposed) mortgage payment, property taxes, and homeowners insurance, etc.
- Back-end DTI Ratio: Includes all recurring monthly payments, providing a comprehensive view of your monthly spending.
What is a Good DTI Ratio?
A LOWER DTI ratio is better. You'll often hear that Lenders generally like a DTI ratio below 43%, as it indicates a lower risk of default, but while the DTI ratio is critical, it’s not the only factor lenders consider. There are "hard cut offs" for different loan types. VA backed loans DO NOT HAVE A DTI RATIO MAXIMUM set forth by the VA. There are other factors that determine whether a VA borrower will be approved. It's called residual income, and it's determined based on the amount of money the borrower is left with after all expenses are paid monthly.
Credit Utilization Ratio
Your credit utilization ratio measures how much credit you use relative to your credit limit. This is a major determining factor for your FICO scores. It also impacts your mortgage loan approval.
Calculation:
Current balance / Credit limit x 100 = Credit Utilization Ratio
Example:
- Credit limit: $15,000
- Current balance: $5,000
5000 / 15000 x 100 = 33%
Aim to keep your credit utilization below 30%.
Why Improving Your DTI Ratio is Important
A low DTI ratio shows you manage your debt and income well. Conversely, a high DTI ratio suggests you might have too much debt relative to your income. Improving your DTI ratio can enhance your mortgage prospects.
Tips to Lower Your DTI Ratio
- Limit Spending: Create and stick to a budget to reduce debt.
- Pay Off Debt: Focus on paying off all forms of debt.
- Target High-Interest Debt: Use the debt avalanche method to pay off high-interest debt first.
- Avoid New Credit: Avoid taking on new debt, such as financing large purchases or applying for new credit cards.
Does DTI Ratio Affect Credit Score?
Your DTI ratio doesn’t directly impact your credit score, but lenders consider both when evaluating your mortgage eligibility. Regularly check your credit report to stay informed about your credit history!
FAQs About DTI Ratio
How do self-employed individuals calculate DTI ratio?
Lenders may ask for the last two years of income and expenses, profit and loss statements, and bank statements to verify income. Consult with a mortgage professional to accurately get this number.
What DTI ratio do I need to buy a house?
Aim for a DTI ratio under 43% for an easy and stress-free experience . However, remember that VA loan approval is not determined based on just DTI ratio.
Buying a home can be complex. Let our mortgage experts guide you from start to finish. Contact us with any questions you have!