Lenders consider several factors when approving you for a loan. One of the most important factors in determining whether you can repay the loan is your debt-to-income ratio (DTI). The debt-to-income ratio is a comparison of your monthly debt obligations to your gross monthly income. While lenders will use your DTI to evaluate you as a potential borrower, you can also use this ratio to evaluate your own financial health and assess whether you can afford to borrow more.
How to Calculate Your DTI
There are two types of debt-to-income ratios: the front-end DTI and the back-end DTI. The front-end DTI will only consider housing-related debts like your mortgage payment, insurance, taxes, and HOA fees. This DTI is primarily used to evaluate you for a mortgage. The back-end DTI includes all regular debt obligations:
- Monthly rent or house payment (including insurance and taxes)
- Alimony or child support payments
- Car loan payment
- Student loan payment
- Other monthly loan payments
- Credit card payments (the monthly minimum payment)
Expenses like gas, utilities, and groceries are not included in your DTI. Calculating your DTI is very simple.
- Add up monthly debt payments.
- Divide the total debt by your gross monthly income (before taxes).
- The result is your DTI as a percentage.
As an example, let’s say you have gross monthly income of $6,000. You have a $1,500 mortgage payment, a $100 car loan, and $400 in other monthly debt obligations. This means your total monthly debt obligation is $2,000. To calculate your DTI, divide 2,000 by 6,000 to get 0.33 or 33%. Your debt-to-income ratio is 33%.
Why Your Debt-to-Income Ratio Matters
Lenders evaluate your DTI before approving you for a personal loan, credit card, and especially a mortgage. DTI gives lenders a basic risk factor. With this number, a lender can se whether you tend to spend a lot of money compared to what you bring in. Even if you have a large income that could normally support the mortgage amount you want, a debt level that is disproportionately large indicates you may be a financial risk as even a minor disruption like car repairs or an appliance that needs to be replaced can make it difficult to pay your bills. If your debt-to-income ratio is too high, you can be turned down for a loan. This is especially true with a mortgage. Many mortgage programs and lenders have caps on the allowed DTI. It’s possible to get approved if your DTI is slightly too high, but don’t count on it. Historically, qualifying for a conventional mortgage requires a DTI of no more than 28% (front-end) or a 36% back-end DTI. FHA and VA loans allow higher DTI ratios in the low- to mid-40% range because these loans are government-backed.
Tips for Reducing Your DTI
- Increase your down payment. If you’re buying a home and your DTI is too high for the expected housing payment, try cutting back on your spending for six months to increase your down payment. The higher the down payment, the less you need to borrow and the lower your ultimate mortgage payment.
- Reduce your credit card balances. Your credit utilization ratio (or the amount of debt you have relative to your credit limits) is a major part of your credit score. The more debt you have, the higher your DTI as well. Make it a goal to reduce your credit card balances to no more than 10-20% of your total credit limit and no more than 10% to 20% of the credit limit on any given card.
- Scale back your home goals. If you can’t get approved to buy the home you want because your DTI is too high, it may be in your best interest to look for a less expensive home that better fits your current income and debt load.
Christine has a solid background in personal finance as she spent the last eight years working at one of the biggest banks in the US. She managed her own team of financial advisors that helped hundreds of people with their financing needs. Her innate understanding of different financial products and loans helped her move up the ranks quickly after graduating with a degree in Business Administration.