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What Is a Debt-to-Income Ratio (DTI) and How Does It Work?

When considering buying a home, you should get familiar with your debt-to-income ratio (DTI). A home purchase could be risky if you already have a high level of debt compared to your income. Even if you’re willing to take the risk, you may struggle to find a lender who will accept your high DTI.

In this article, we will go over what DTI is, how it works, and how it affects your mortgage application so that you are prepared when you begin shopping for homes.

What Is Debt-To-Income Ratio?

Your debt-to-income ratio, or DTI, tells lenders how much you spend on monthly debt payments compared to how much you earn each month. Calculate your DTI by adding up your monthly minimum debt payments and dividing them by your monthly pre-tax income.

When you apply for a mortgage, you must meet the maximum DTI requirements so the lender knows you will not take on more debt than you can handle. Lenders prefer borrowers with a lower DTI because it shows that you’re less likely to default on your loan.

A lender may consider two types of DTI during the mortgage process: front-end and back-end.

Front-End DTI

The front-end DTI only includes housing-related expenses. To calculate this, use your current monthly mortgage or rent payment, including property taxes and homeowners insurance plus any applicable homeowners association dues.

Lenders usually won’t worry about this number when reviewing your mortgage application. However, it can give you an idea of your financial situation and how much home you can realistically afford.

Back-End DTI

The back-end DTI includes all your minimum required monthly debts. Aside from housing-related expenses, back-end DTIs include any required minimum monthly payments a lender finds on your credit report. Among these are debts like credit cards, student loans, auto loans, and personal loans.

Your back-end DTI is the number that most lenders focus on because it gives them a better understanding of your monthly spending.

Why Your DTI Is Important

When considering mortgage applications, lenders want to ensure that borrowers are qualified for the loan before issuing it. In other words, they expect you to be able to make your mortgage payments on time each month for the rest of the loan’s term. If you cannot afford to pay and decide to default on the loan, the lender risks losing money.

Your lender can better understand your financial situation by looking at your DTI. The ratio shows them how much debt you have relative to your monthly income so they can determine whether you can cover the cost of a mortgage on top of any existing debt you have.

What Counts As A Good DTI Ratio?

Most lenders prefer applicants with DTI ratios of 43% or less. However, it’s helpful to understand how different ranges can affect your chances of approval when applying for a mortgage .

  • Over 50% : A debt-to-income ratio of 50% or higher indicates that you have a high level of debt and are not financially prepared to take on a mortgage loan. Lenders will often deny applicants loans if their ratios are this high.
  • 43% to 50%: Ratios falling in this range often indicate that you have a lot of debt and may not be ready to take on a mortgage loan.
  • 36% to 41% : Ratios in this range show lenders that you have a reasonable amount of debt and still have enough income to cover the cost of a mortgage should you get one. People with these DTIs have a higher chance of getting a loan approved by lenders.
  • Below 36%: A DTI ratio below 36% shows lenders that you indeed have a reasonable level of debt. No need to worry about having trouble qualifying for new loans or lines of credit.

Knowing your DTI will help you decide if now is the right time to buy a house. Waiting may be a better option if you have a high DTI ratio. However, if your ratio is low, you can take advantage of it and apply for a home loan.

DTI Formula and Calculation

The debt-to-income (DTI) ratio is a personal finance measure comparing an individual’s monthly debt payment to their monthly gross income. The gross income you earn is the sum of all your earnings before taxes and other deductions. The debt-to-income ratio is the percentage of the gross monthly income you use to pay your monthly debt payments.

The DTI ratio is one of the metrics that lenders, including mortgage lenders, use to measure an individual’s ability to repay debts and manage monthly payments.

Debt-to-Income Ratio Limitations

Even though DTI ratios are important, they are only one of the financial ratios or metrics considered when making a credit decision. A borrower's credit history and credit score are also significant factors in determining whether to extend credit to a borrower. A credit score is a numeric value of your ability to repay debt. Several factors impact a score negatively or positively, including late payments, delinquencies, number of open credit accounts, balances on credit cards relative to their credit limits, or credit utilization.

DTI does not distinguish between different types of debt and the cost of servicing that debt. Credit cards carry higher interest rates than student loans, yet they're lumped together in the DTI ratio calculation. Transferring your high-interest rate cards to a low-interest credit card would lower your monthly payments. As a result, your monthly debt payments and DTI ratio would decrease, but your total outstanding debt  would remain the same.

Having a low debt-to-income ratio is a key factor when applying for credit, but it's not the only one used by lenders.

How to Lower a Debt-to-Income Ratio

You can lower your debt-to-income ratio by decreasing your monthly recurring debt or increasing your gross monthly income.

For example, if John's recurring monthly debt is $2,000, but his gross monthly income is $8,000, he would have a debt-to-income ratio of 0.25 or 25%.

Similarly, if John's income remains at $6,000, but he pays off his car loan, his monthly recurring debt payments would fall to $1,500 since the car payment was $500 per month. Hence, John's DTI would be $1,500 ÷ $6,000 = 0.25 or 25%.

If John is able to reduce both his monthly debt payments to $1,500 and increase his gross monthly income to $8,000, then his DTI ratio will be as $1,500 ÷ $8,000, which equals 0.1875 or 18.75%.

The DTI ratio can also measure the percentage of income that goes toward housing costs, which for renters is the monthly rent amount. An applicant's ability to manage their current debt load while paying their rent is evaluated by the lender.

DTI Requirements By Mortgage Type

The lower your DTI, the better. In general, you'll need a DTI of 50% or less, but your application will determine the specific requirements.

FHA Loans

Mortgages backed by the U.S. Federal Housing Administration are called FHA loans. Compared to other loans, FHA loans  have more lenient qualification requirements. Borrowers require a minimum credit score of 580 to qualify for the loan. FHA loans have a maximum DTI of 57%. However, lenders have the freedom to set their own requirements. Therefore, some lenders may set the maximum DTI at 57%, while others may set it closer to 40%. Do your research and talk to each lender you are considering. They’ll be able to tell you the ranges they accept.

USDA Loans

USDA loans are only available to people who buy or refinance homes in eligible rural areas. To qualify for a USDA loan , you must have a DTI of less than 41%.

There are a couple of unique requirements for USDA loans. First, you cannot get a USDA loan if your household income exceeds 115% of the median income in your area.

Second, your lender will consider the income of everyone in the household when determining your eligibility for a USDA loan. In other words, they’ll need to verify income for all household members – regardless of their involvement in the loan.

When determining whether your DTI qualifies you for a USDA loan, your lender will only consider the income and debts of the loan applicants. If you have other occupants in your home, their income will only play a role in determining whether your household meets the income limits. It won’t contribute to your DTI.

VA Loans

VA loans, backed by the Department of Veterans Affairs, provide low-cost home loans to current and former military personnel and their surviving spouses. VA loans don’t require a downpayment and often have more lenient DTI requirements. You might be able to get a VA loan with a DTI of up to 60% in some cases.

However, each lender will set their own requirements. Get in touch with your lender to find out what they require. If you meet their qualifications, you may be able to save money by choosing a VA loan.

Conventional Loans

Conventional loans do not have a single set of requirements. The DTI requirement will vary depending on your personal circumstances and the type of loan. However, conventional loans generally require a DTI of 50% or less. If your DTI is high, you'll need to prepare high cash reserves to offset your high levels of debt.

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