Debt-to-income ratio (DTI) is one of the most significant factors mortgage lenders consider when reviewing your loan application.
During the review, lenders assess your employment history, available down payment, liquid assets, and collateral. However, the information that has the most impact on whether your application is approved is your credit history, credit score, and debt-to-income ratio.
These data points are strong indicators of how likely you are to repay a loan because they provide insight into how you managed debt in the past and how financially capable you are of taking on additional debt.
Calculating your debt-to-income ratio before submitting a mortgage application can help streamline the process by identifying whether your DTI is within an acceptable range for the type of loan you are applying for.
DTI is a comparison of how much money you owe each month to how much money you earn. In other words, it's the percentage of your gross monthly income that goes toward expenses such as rent or your current mortgage, credit cards, car payments, student loans, and other debt. If you are applying for a Veterans Affairs (VA) loan, the lender will also factor taxes and childcare expenses into your DTI.
Your DTI is significant when applying for a home loan because lenders use the information to evaluate your readiness to take on more debt. The lower your DTI, the lower the perceived risk to the lender because, at least on paper, you have the financial capacity to make your loan payment every month.
To calculate your DTI, you first need to take an inventory of your monthly debt, including housing, credit cards, and student loans. You can exclude expenses such as utility payments, car insurance, and internet service.
Once your debt inventory is complete, you plug the numbers into a simple formula:
DTI = (Monthly debt payments/Gross monthly income) x 100
For example, suppose each month you pay $1,500 for your mortgage, $500 for your student loan payment, and $300 for credit card bills. Your total monthly debt payments add up to $2,300. If your gross monthly income is $5,000, then your debt-to-income ratio can be calculated as ($2,300/$5,000) x 100 = 46 percent.
There is no standard value for debt-to-income ratio. Every lender has its own risk tolerance and sets its own limit. However, within the home loan industry, a “good” DTI normally falls between 30-50 percent, with 43 percent being the cap for many lending institutions.
A higher-than-preferred DTI doesn’t automatically disqualify you from a home loan. Other factors, such as a high credit score or a substantial amount of verifiable cash, may help you get a loan with a less-than-ideal DTI.
Additionally, some loan providers, such as FFB Mortgage Lenders, take a one-on-one approach to lending, treating every customer as an individual and helping them find unique mortgage solutions, even with high or nuanced DTI ratios.
Don’t be discouraged if you complete your debt inventory and discover your DTI is too high. Unlike a poor credit score, there are ways to improve your DTI relatively quickly.
Because DTI compares your income with your debt, you can increase your monthly income, decrease your monthly debt, or both. Asking for a raise at your current job is one option for generating additional income quickly, but it may not be the most effective.
Other possibilities include picking up additional shifts or working longer hours if that is an option in your workplace. If you can’t increase your hours, consider getting a second job, even temporarily, to increase the amount of cash you can apply to your debt.
Even if you can’t bring in more money, you can probably find a way to spend less and free up cash that can be put toward existing debt.
One of the most effective ways to cut your spending is to create a budget and stick to it. However, after you make your budget, you may find that there isn’t any money left over. In this case, look at your outflow and cut back on unnecessary expenses such as take-out meals, coffee shop orders, and streaming services, or sell household items you no longer use.
If your DTI is significantly impacted by high medical debt or credit card bills, try contacting the provider and asking if they offer reduced buy-out prices if you pay off your debt in a lump sum. That’s a fast and easy way to potentially reduce your debt by hundreds, or even thousands, of dollars.
[NOTE: At First Federal Bank Mortgage Lenders, we are mortgage experts, not financial advisors. Always check with a licensed financial professional before making major financial decisions.]
Your debt-to-income ratio is a significant factor in applying for a loan. Your DTI influences the type of home loan you qualify for as well as interest rate, down payment, and repayment period. Knowing how to calculate your debt-to-income ratio and proactively assessing your ability to comfortably add the financial responsibility of a home before applying for a mortgage can help you stress less about the homebuying journey.
Curious whether you qualify for a VA loan? Unsure how much downpayment you need? Check out VA Loans 101, an essential resource for homebuyers who want straight answers to their homebuying questions.