Throughout the mortgage process, your home lender may use a variety of industry jargon or acronyms when communicating with you about your loan application. While all these phrases are important to understand, pay extra attention when your lender talks about your DTI or debt-to-income ratio.
DTI measures a borrower’s monthly debt payments compared to their monthly gross (pre-tax) income. Things like credit card, auto, and student loan payments are all factored into your debt-to-income ratio.
Why does DTI matter?
Lender’s put a lot of emphasis on a person’s debt-to-income ratio when it comes to qualifying for a home mortgage. While it’s not the only qualifying factor lenders consider, if a borrower’s DTI exceeds a certain threshold, they may not qualify for financing.
A low debt-to-income ratio indicates to lenders that you can comfortably afford to make your monthly payments based on your current income. A lower DTI means you're likely to manage your debt more effectively and are at less risk of financial distress.
Conversely, a high debt-to-income ratio could be a sign that you have too much debt or don't earn enough to keep up with your current monthly obligations—you could also be at a higher risk of default.
Front-end versus back-end DTI
Lenders often divide debt-to-income ratio into two calculations: front-end and back-end DTI. Both are important when analyzing your ability to repay.
The front-end ratio takes into consideration only your proposed monthly mortgage payment compared to your monthly gross earnings. It shows how much of your monthly income will be spent specifically by your housing payment. Most lenders will want your front-end ratio to measure between 28-36%.
Your back-end DTI considers all of your debts in relation to your monthly gross income. This is often the more important ratio of the two since it encompasses all debts. Typically, lenders don’t want your back-end ratio to exceed 43-45%, although some mortgage programs allow a maximum back-end ratio as high as 50%.
How to calculate your DTI ratio
Calculating your debt-to-income ratio yourself isn’t terribly difficult, and since it can impact how much you can borrow, it’s a good number to know before you start the home buying process.
First, figure out your total gross monthly income, which is the amount of money you earn before taxes and other pre-tax deductions. For your debt payments, consider all your monthly loan payments including credit cards and auto loans.
Let’s look at an example where Sam is trying to qualify for a new mortgage and is calculating her debt-to-income ratio. Sam’s gross earnings are $1,200 bi-weekly. She also has an auto loan, personal loan, and a credit card for personal expenses.
Sam’s Monthly Gross Income | Sam’s Monthly Debts |
Annual gross income: $1,200 x 26 = $31,200
Monthly gross income: $31,200 ÷ 12 = $2,600 |
· Mortgage loan: $800 · Auto loan: $125 · Personal loan: $100 · Credit cards: $25
Combine total monthly debt payment: $800 + $125 + $100 + $25= $1,050
|
Calculate Sam’s front- and back-end debt-to-income ratios by dividing the debts over gross monthly income:
Front-end: $800 ÷ $2,600 = 30.7%
Back-end: $1,050 ÷ $2,600 = 40.3%
In general, a lower DTI ratio is favorable because it indicates less risk for lenders. If you have a high DTI ratio, you might consider ways to decrease your debt. For example, you could bring your number down by borrowing money from family to pay off a credit card, eliminating gym or other memberships, and scaling back on other non-essential expenses.
Comments