Your Debt-to-Income Ratio: What It Is and How it Impacts Your Ability to Get a Mortgage

Your debt-to-income ratio is one of the key factors in qualifying for a new home loan. But how much do you really know about this important calculation and what can you do to move it in your favor?

Your debt-to-income ratio, or DTI, is used by mortgage lenders in making a decision regarding your worthiness for a home loan. If your DTI is too high, you could end up paying a higher interest rate or worse yet, be denied the loan entirely. Lenders consider it an important measure to ensure you don’t get in over your head when it comes to your new home purchase.

Here’s how it’s calculated

A DTI for mortgage approval is actually a very simple ratio. Its purpose is to measure how much of your income is used each month to pay down your current debt obligations. Your lender calculates your DTI ratio by adding all required minimum payments on your credit cards, installment loans and other debts, then comparing it to what you earn each month. In figuring your income, they use your gross, or pre-tax, amount. In addition, only minimum required payments on your debt is used, even if you make it a habit to pay more than the minimum.

Let’s look at an example:

Aaron and Emma are first-time homebuyers, getting ready to apply for a mortgage. Their gross monthly income together is $7,500. Now, let’s look at their debts:

• Aaron’s $250 monthly car payment
• Emma’s $325 monthly car payment
• A total of $65 minimum payment on credit card debit
• A $200 student loan payment
• $1,400 in proposed monthly housing costs (the anticipated monthly mortgage for the home they want to buy, as well as insurance, taxes and HOA fees)

Their total monthly debt under the above scenario would be $2,240. Dividing this amount by their monthly income of $7,500 reveals a debt-to-income ratio for their mortgage approval of 29.8%. So, what does this mean to the lender?

Here’s what lenders are looking for

Most mortgage lenders actually look at two different debt-to-income ratios when they’re considering whether or not a applicant is credit worthy. These two ratios are referred to as the front-end ratio and the back-end ratio.

• The front-end ratio. The front-end ratio is limited to your housing costs only and how it relates to your income. It takes into account your anticipated principal and interest payment, along with your property taxes, insurance and any HOA fees. This amount is then divided by your income to arrive at your front-end debt-to-ratio income. Most lenders will want to see a front-end ratio of 28% or below. In the above example, Aaron and Emma have a front-end ratio of 18.7%, well within the boundaries.
• The back-end ratio. This is the more important of the two ratios. Lenders will sometimes give if a front-end ratio is slightly high if you have no other debt payments since your total financial obligations are manageable, despite the larger mortgage payment. The back-end ratio is critical, however. It considers not only your housing costs, but all your other debt obligations. Lenders prefer to see this number at 38% or lower, though it depends on the loan product you’re going to use. Some FHA loans, for example, may allow a back-end ratio of up to 50%. In our above example, as we already saw, this couple’s back-end ratio would be 29.8%. Again, they are well below the threshold.

Here’s how you can improve your ratios

If you calculate your DTI ratios and find that they are probably too high to qualify for a mortgage, there’s good news. Your ratios are within your own control. All it takes is discipline, commitment to the end game and patience. Here are the three ways to improve DTI:

• Increase your income. Whether it is taking a better-paying job or adding an additional income stream, increasing your total income will improve your DTI ratios, even if you do nothing else.
• Reduce your debt. You should be aggressive when it comes to paying down debt. The lower the balance on credit cards, the lower your payments, so start there. You should also work to pay off any installment loans if the balance is doable. Finally, you may be able to refinance your vehicle loan in a way that results in lower monthly payments.
• Choose a lower-priced home. If you have maximized your income opportunities and addressed your monthly debt, it may be that you’re simply trying to purchase a house that’s beyond your current means. Set your sights on a more reasonably priced home by working your calculation using progressively lower monthly home costs until you reach an amount that results in qualifying ratios. This will tell you how much home you can comfortably afford. Your lender can also help you arrive at this number.