Credit score and job stability aside, your debt-to-income ratio is one of the most important factors mortgage lenders use to evaluate your creditworthiness because in tells the lender where you sit financially and if you can afford to take on loan. Simply put, your debt-to-income ratio for a mortgage is all your monthly debt payments divided by your gross income. This looks at the amount of money you make prior to tax deductions when you subtract all your debt obligations for the month (student loans, car payments, credit cards, etc.).
For example if, you pay $2,000 in monthly rent, another $200 for your car payments and $400 a month for the rest of your debts, then your monthly debt payments would be $2,600. It then compares this number to how much you make, so if your gross monthly income is $5,500, then your DTI would be 47% ($2,600 divided by $5,500). When it comes to getting a mortgage, prospective homeowners often focus on their credit scores, but overlook the overall state of their finances, so debt-to-income ratio (DTI) is a way to understand where you sit financially.
How to Calculate Your Debt-to-Income Ratio
Types of Debt-to-Income Ratios
When lenders evaluate if you are ready for a mortgage, they look at two types of debt-to-income ratios: your front-end ratio and back-end ratio. While they evaluate different things, each ratio offers a comparison of your current debt amounts to your gross monthly income that helps the lender determine how much they can realistically lend a prospective homeowner. To better understand how DTI impacts your ability to get a mortgage, you must first understand the difference between the two.
Commonly known as the mortgage-to-income ratio, the front-end debt ratio is calculated by dividing your anticipated monthly mortgage payment by your monthly gross income. Your anticipated mortgage payment looks at the principal of the loan, interest, taxes, and mortgage insurance (PITI).
The back-end ratio is more commonly known as your debt-to-income ratio and gives a broader look at where you sit financially in relation to the state of your debt. Previously mentioned, this evaluates your vehicle loans, personal loans, student debt payments, credit card payments and any other kind of monthly debt you might have. This total number is then divided by your monthly gross income to calculate your back-end ratio.
Maximum vs. Recommended Ratio for Mortgages
Now that you understand the two different types of DTI, it’s important to know what percent lenders recommend. After calculating your debt-to-income ratio, the maximum DTI that a prospective homebuyer can have is 43%. Any ratio higher than 43% tells a lender that the prospective homeowner can’t afford to take on any additional debt and is considered too risky.
There are exceptions — in some cases with Federal Housing Administration loans, the recommended debt-to-income limit is potentially higher. Their approval system can even accept ratios as high as 46.99% for the front-end and 56.99% for the total back-end ratio, but when half of a borrower’s income is already tied up in debt, this can put an individual in a dire financial situation.
While 43% is typically the highest total debt-to-income ratio that a homebuyer can have, some lenders recommend borrowers to sit somewhere closer to 36%. Not only is this considered less risky for the lender, but a homebuyer can benefit from having a lower DTI. Lenders prefer that their borrowers have small monthly payments in relation to their income because this indicates they are less likely to miss payments or default on the loan. A lower ratio also increases the odds that a prospective homebuyer will get approved for a mortgage and have better loan terms.
Debt-to-income ratio may take into account your monthly debt obligations, but it frequently leaves out standard living expenses like food, utilities, transportation and health insurance. Since lenders may overlook these expenses, it’s possible that a borrower could fall into monthly mortgage payments they aren’t financially comfortable making if these aren’t factored into the equation.
How to Improve Your DTI
With a high debt-to-income ratio — over 43% — potential borrowers may find they aren’t ready to take on a mortgage and instead work on improving the overall state of their debt. Prospective homebuyers can help improve their debt-to-income ratio in several ways.
- Avoid taking on more debt.
- Stop making big purchases on credit.
- Pay off high-interest credit cards and consumer debt.
- Increase your income.
While these strategies may be the most obvious ways to help improve your DTI, there are other options to consider. If you primarily have credit card debt, consider looking into a debt management plan or credit card consolidation. With consolidation, a borrower is given one single loan to pay off smaller loans.
This can be beneficial for individuals with a significant amount of credit card debt and typically includes one monthly payment that is easier to manage. In some cases, the monthly payment and interest rates can be lower than having different accounts with several monthly payments.
Can You Get a Mortgage With a High DTI?
There are several ways borrowers can get a mortgage with a high DTI. Depending on your individual circumstances and history, some of these options may be right for you.
Co-signer – In some cases of a high debt-to-income ratio, borrowers may allow for a co-signer or co-borrower to apply alongside the borrower. This is often the case with FHA loans and may improve the loan applicant’s chances of getting approved for the mortgage. This may also be a way for a borrower with established credit to help a less established co-borrower become a homeowner under the proper circumstances.
Increase your down payment – If a lender sees that you are able to pay for a good portion of the house upfront, this may increase your odds of getting approved for a mortgage. A larger down payment can tell a lender you are less likely to walk away from your financial obligations or allow the property to go into foreclosure.
Government programs – Assistance from the government may not apply to every prospective homebuyer, but for those who do, it may be an option to consider that can lighten the burden of a traditional mortgage.
- Federal Housing Administration loans – Several government programs exist to encourage renters to become to home buyers. As mentioned above, Federal Housing Administration (FHA) loans allow borrowers to get into a home with a high debt to income ratio — sometimes as high as 57%. This also allows for a higher mortgage payment amount than the buyer might normally qualify to pay.
- VA loans – Veterans and active duty military members may also qualify for government assistance when it comes to buying a home. Commonly known as VA loans, Veterans Affairs mortgages are somewhat easier to qualify for compared to conventional loans. Some of their perks include little to no down payment, no minimum credit score, no mortgage insurance and total debt-to-income ratio as high as 41%. The loans are made through private lenders and guaranteed by the Department of Veteran Affairs.
It’s the American dream to own a home, but this often comes with strings attached — getting a mortgage is not a simple black and white decision as there are many factors to consider. Regardless, it benefits both the borrower and lender to take on a mortgage with a relatively low debt-to-income ratio. The Federal Reserve considers a debt-to-income of 40% or more a sign of financial stress. An approval with a high DTI doesn’t always mean it’s the best move to take out a mortgage. Because a high DTI is often correlated with financial stress, it may be prudent to wait on your dream home and focus on reducing the size of your debt first.