What is Debt-to-Income Ratio?
Debt-to-Income ratio is a percentage that tells lenders how much of your money you are spending each month versus the amount you have coming in. Your DTI is calculated using your total monthly obligations and dividing them into your total monthly gross income. This number will be a percentage known as your debt-to-income ratio or DTI.
Lenders have maximum debt-to-income ratio restrictions when you are applying for a home loan. You’ll need to meet these maximums in order to qualify for the loan.
The lower your debt-to-income the more favorable lenders will see you. Lower DTI borrowers are less likely to default (stop paying) on their mortgage.
Higer DTI ratios can indicate that you are borrowing more money than you can afford. High DTI borrowers can often have trouble making their payments on time.
There are two different types of Debt-to-Income Ratios to consider:
- Front-End Ratio: Your front end ratio is the amount of your housing payment divided into the income.
- Back-End Ratio: Your backend DTI is all of your monthly debt expenses plus your mortgage payment divided into your gross monthly income.
Your back end dti shows a more complete picture of your current monthly spending and how leveraged you are. Lenders will include your monthly debts listed on your credit report as well as other debts like student loans, child support payments, income tax payment plans and other monthly debts the underwrite may find.
How to Calculate Your Debt-to-Income Ratio
In order to calculate your debt-to-income ratio you’ll need to add up your monthly debts and divide them by your gross monthly income.
1. Add Up All Of Your Monthly Debts
When adding up your debts it’s important to remember that the only debts you need to include are the ones that are required and recurring payments for debts you have. You’ll want to use the minimum monthly payments due, not the amount owed.
IF you have more than one person applying for the loan you’ll want to add each applicant’s debts as listed below.
When adding up your debts you should include items such as:
- Car Notes
- Personal Loans
- Student Loans
- Credit Cards
- Child Support
- Your Future Mortgage Payment
- HOA Fees
Items that you won’t be required to calculate in your DTI include:
- Gas bill
- Electric bill
- Cell Phone bill
- Water bill
- Cable bill
- Car insurance
- Or any other bills that aren’t debt related.
- Health Insurance
- Entertain, Food & Clothing
- Transportation Expenses
Here’s an example of how to calculate your debt-to-income ratio:
- Mortgage: $1200
- Student Loan: $50
- Credit Card: $100
- Auto Loan: $600
In this example you’d add all these together which would total: $1950 in minimum monthly payments.
2. Divide Your Monthly Payment By Your Gross Monthly Income
Your gross monthly income is the amount of money you earn before you pay any taxes, health insurance or retirement benefits. If you have multiple people applying for the loan you’ll want to add both persons’ income.
Let’s say in this example it’s just you applying and you make $60,000 per year.
$60,000\ 12= $5,000. Your gross monthly income would be $5,0000.
3. Convert Your Results to a Percentage
$1950 / $5,0000=0.39
0.39 x 100 = 39%
In this example you would have a Backend DTI Ratio of 39%
How to Calculate Front-End DTI Ratio:
To calculate your front-end dti ratio you would follow a similar process as above. The only difference is that instead of using all of your debts you’d only use your housing payment.
Here’s what that would look like:
Mortgage Payment of $1200 / Monthly Gross Income of $5,000 = 0.24
0.24 x 100 = 24 so your front-end ratio would be 24%
Why does DTI matter?
Debt-to-Income Ratio is important because it’s one of the primary ways that a lender determines how much house you can afford. Each loan program has a maximum allowed dti ratio.
Some lenders will even place overlays on those requirements to make them even lower. It’s common for most banks to restrict their DTI maximum to 45% or less.
Having a high debt-to-income ratio can make it harder to juggle your bills each month. When your debt payments start to eat up 50% or more of your income it makes it hard to keep up with your payments or cover unexpected expenses and emergencies.
What debt-to-income ratio is needed to get a mortgage ?
So the next logical question is what is a good DTI ratio? If you are keeping your DTI under 45% most lenders would say you are in a good spot. However, most loan programs will allow you to carry a DTI ratio higher than that.
FHA: FHA loans have a maximum backend DTI ratio of 57%. However borrowers with lower credit scores may struggle to get approve with ratios over 43% 50%.
USDA: USDA Loans have a front end DTI restriction of 29% and a backend DTI of 43%. High credit borrower may be able to go up to 45%.
VA: VA loans don’t have a DTI restriction unlike all other programs. VA loans follow residual income requirements which measure all of the borrowers monthly expenses. While VA doesn’t impost these requirements many lender will cap your backend DTI ratio at 65% or less.
Conventional : Conventional loans are loans issues by Fannie Mae and Freddie Mac. The maximum allowed back-end DTI ratio for Conventional loans is under 50%. Most borrowers will need their front-end ratio to be under 36%.
How to lower your debt-to-income ratio
Having a high DTI ratio can be frustrating because it can prevent you from purchasing a home. Here’s a few ways you can lower your DTI ratio.
- Pay off Debt: The quickest way to reduce your debt-to-income ratio is to pay off debt. Reducing your monthly debt payments will go a long way in helping you to reduce your DTI.
- Increase Your Income: While not the easiest thing to do, if you find yourself in a position where you can obtain a higher paying job, this can also help to lower your DT
One word of caution is that if you obtain a job earning overtime, commission, bonus or you get a side hustle or become self-employed; you’ll need a two year history before your lender can include the additional income.
- Add Someone to the Loan: If you have a co borrower you can add, their income can offset debts and help to reduce your DTI. We will need to use the co-borrowers credit history and score so keep this in mind when applying.
- Consider a debt consolidation loan: If you have a decent credit score or a relationship with a local bank or credit union, a Debt Consolidation loan could work for you.
You’ll want to add up what you need to pay off and their payments and then see what the new loan payment will be.
As you can see your DTI plays a large role in your ability to be approved for a home loan. Your DTI is going to limit how much of a home you can afford.
If you have a DTI under 50% you won’t be over any of our loan programs at Bayou Mortgage. If it’s between 50%-57% you may still qualify for an FHA Loan.