What’s a Good Debt-to-Income Ratio?
When it’s time to seek home financing, it helps to know how much you can afford before getting your heart set on something that’s out of your price range. One quick way to determine an amount is to calculate your debt-to-income (DTI) ratio.
This is a major factor, along with credit score, that lenders consider when issuing a mortgage loan. Keep reading to learn more, then follow our home buyer tips to impact your DTI ratio.
What is debt-to-income ratio?
Debt-to-income ratio, also known as DTI ratio or DTIR, is an expression of the amount of money you owe compared with your income.
To calculate DTI ratio, add up monthly recurring debts. Include amounts owed to creditors, not the amounts paid for expenditures like utilities, rent or insurance. Examples include credit cards, personal loans, auto loans, and student loans. Include court-required payments, like child support, as well.
Now, calculate gross monthly income – amount earned before any taxes, social security or other payments are removed. Add in any additional court-ordered payments received, such as child support or alimony.
To get your DTI ratio, divide the total amounts owed to creditors each month by the gross monthly income. Multiply it by 100 to get the percentage.
For example, if your minimum credit card payment is $200 and you have a $400 car payment and $100 student loan, your monthly debts are $700. If your annual salary is $84,000, that’s a gross income of $7,000 a month. Divide $700 by $7,000 to get 0.10. Multiply that by 100, and your DTI is 10%.
This example was kept simple – that’s a very low DTI ratio, for sure!
How does debt-to-income ratio affect home financing?
DTI ratio does not impact credit score, but it does impact home financing!
For mortgage lenders, DTI ratio is a good predictor of a home buyer’s ability to repay the loan. Once the mortgage payment is calculated as a ratio, there should still be some wiggle room in a home buyer’s budget. This way, if an unexpected circumstance inhibits their ability to pay, the home buyer is more likely to have funds to stay current on their mortgage.
Some lenders only consider DTI ratio when they offer a quick pre-qualification for a loan. They’ll compare monthly income to monthly debt payments, determine a monthly payment amount that keeps the buyer within the preferred DTI ratio, and pre-qualify the potential borrower for the loan amount that results in that monthly payment.
Many buyers pursue purchases without getting pre-qualified or pre-approved, and they often seek loans that would result in monthly payments they can’t afford. In fact, while many people are uber-focused on credit score, DTI ratio is actually the number one reason mortgage loans are denied.
What’s a good target for a DTI ratio?
Some lenders consider a potential borrower with a DTI ratio below 35% someone who has well- managed debt, up to 49% as someone with opportunities to improve, and 50% or more someone who is not ready to take on more debt.
However, mortgage loans are available with higher DTI ratios, including 50% or even more. Potential buyers with high DTI ratios may need to speak with multiple lenders to find the right loan for them.
Home buyer tips for improving debt-to-income ratio
Like improving a credit score, improving debt-to-income ratio typically takes a combination of time and good habits.
Pay down credit debt: Pay down debt as much as possible to reduce those monthly payments and avoid accessing new credit.
Divert savings: Talk to your lender about whether it may be beneficial to divert some money set aside in savings or for a down payment toward paying down debt instead.
Increase income: Is it time to change jobs or pick up a side income? Even a temporary lift in income can help by either raising the income portion of the equation or raising cash to pay off debts.
Consider the timing: It may be beneficial to wait until the year-end bonus or the cost-of-living raise comes through to purchase.
Purchase a less expensive home: Lenders consider the debt-to-income ratio that will be in place after the mortgage is issued. Purchasing a less expensive home will mean a lower payment and a better DTI ratio.
Top home buyer tip:
When looking for a home, it’s easy to get caught up in the fun of the search and forget the requirements for home financing. Credit scores and debt-to-income ratios are just two of the many factors considered. It’s best to avoid surprises by consulting with a mortgage lender early in the home search process.