Debt-to-Income Ratio (DTI)

Brian Carberry

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Debt-to-income (DTI) ratio is the amount of a consumer’s current or future monthly debt obligations divided by their pre-tax, or gross, income. These ratios are almost exclusively used by lenders during the homebuying process but will also be considered when taking out auto loans or other large loans. They calculate buyers’ debt-to-income ratios to determine if they can financially bear the new loan’s monthly payments. In essence, they’re a quick way to figure out how much debt you have compared to your gross monthly income.

If you have a high debt-to-income, it means you are highly leveraged and have tight finances, which, naturally, is considered risky from a lending standpoint. If your monthly debt payments are high, you might be less likely to pay a mortgage on time. On the other hand, if your debt-to-income ratio is low, the lender knows you have plenty of room in your monthly budget to absorb unexpected expenses and still pay your mortgage.

Calculating Your Debt-to-income Ratio

If you’re in the market for a home loan, it doesn’t hurt to calculate your debt-to-income ratio ahead of time so you understand your true financial situation. To do this, simply tally up your total monthly debt payments and divide them by your gross monthly income.

Either obtain a recent copy of your credit report or gather up your most recent statements for all your debt obligations. Note that only debt obligations are included in your DTI — not utility, phone, cable bills, or any other regular payments.

Tally up your minimum monthly payments for all debts, including car loans, minimum credit card payments, credit lines, student loans, child support obligations, and any other debt obligations that you have. If you have an American Express credit card, use 5% of the outstanding balance if the minimum payment is showing as the full balance on your credit report.

Add your rent or home mortgage payment, including monthly property taxes, homeowner’s insurance, homeowner’s association (HOA) fees, and private mortgage insurance (PMI) premiums.

Divide your total monthly debt payments by your gross monthly income, assuming you’re a W-2 wage earner, then multiply by 100 to get a percentage.

If you’re self-employed, I recommend working with your loan agent to determine your qualifying DTI. Self-employed income verification is more complicated and there’s no way to determine your qualifying monthly income definitively without tax returns.

Keep in mind that when you’re qualifying for a home loan, your qualifying debt-to-income ratio will be based on what your expenses will be after the loan is complete. In other words, if you’re currently renting and are taking on a house payment higher than what you’re paying for rent, your qualifying DTI will be based on the new mortgage payment. If you’re refinancing and consolidating debts, your qualifying DTI will reflect your expenses after the various debts are consolidated.

The lender will also calculate your debt-to-income ratio when applying for a mortgage. There are two different ratios they might calculate: the front-end debt-income ratio and the back-end debt-income ratio. We’ll discuss those later, but first, let’s look at an example of a debt-to-income ratio calculation and discuss what a good debt-to-income ratio looks like.

Debt-to-income Ratio Example 

To calculate your monthly debt-to-income ratio, you need to know what you pay toward debt payments each month. Use the minimum monthly payment for your calculation, not the amount you typically pay or the amount you owe. Keep in mind that you aren’t including the payments you make for your household bills. Your calculation can often include:

  • Mortgage payments.
  • Property tax payments.
  • Homeowner’s insurance payments.
  • Student loan payments.
  • Credit card payments.
  • Auto loan payments.
  • Child support or alimony payments.

The other thing you need to know to calculate your debt-to-income ratio is your gross monthly income. This is the pre-tax amount you make each month. You’ll need to include the monthly debt and income of each person whose name will be on the loan.

Here’s an example:

  • $3,500 = monthly debt payments.
  • $7,000 = gross monthly income.
  • $3,500/$7,000 = 0.5.

The final step of the calculation is to convert the sum to a percentage. In this case, the debt-to-income ratio is 50%.

What Is a Good Debt-to-income Ratio?

A good DTI will depend on the type of loan, but in most cases, the lower the debt-to-income ratio a borrower has, the more likely they are to be approved for a loan. Lenders like to see a debt-to-income ratio of under 50%, but some loans may allow for a higher DTI ratio. FHA loans, for example, have a 57% maximum debt-to-income ratio allotment. It will be up to the lender to determine your risk as a borrower and whether they’ll loan to you with a higher DTI.

With a VA loan, some borrowers may get away with having a DTI of up to 60%. Of course, a higher debt load will require the bank to charge higher interest rates to borrowers due to the risk. Someone close to maximizing their credit limit is a bigger risk than someone with little to no monthly debt obligations. Qualifying for a conventional loan also requires a DTI of 50% or less, but these loans can be harder to get, so it’s better to have less debt if you hope to use one.  

You can discuss your loan options with your lender to determine the best type of loan for your financial situation. Consider taking steps to lower your DTI before applying for a mortgage if you want to have more financing options.

What Is the Front-end Debt-to-income Ratio?

The front-end DTI measures the percentage of gross, or pretax, monthly income that would go toward a new mortgage or loan payment. It directly affects the housing costs a homebuyer can be approved for. 

For mortgages, a prospective lender will calculate how much of the borrower’s gross monthly income would go toward housing expenses, which include:

  • Principle.
  • Interest.
  • Property taxes.
  • Homeowner’s insurance.

This bundle of payments is commonly called “PITI.” Here’s an example of how this might play out:

  • Gross monthly income: $5,800.
  • Mortgage: $1,450.
  • Debt-to-income ratio: 25%.

Typically, lenders will want to see front-end ratios below 30% before approving a borrower for a mortgage. High credit scores and high monthly incomes may make a sub-30% ratio less vital.

Some lenders will still approve a loan with a debt-to-income ratio over 34% to 36%, but the terms of the loan may be more onerous. Typically, this means a higher interest rate, which compensates for the extra risk taken by the lender.

If the borrower is applying for a personal or auto loan, then lenders may instead calculate the borrower’s current rent payment in relation to monthly income.

What Is Back-end Debt-to-income Ratio?

The back-end DTI measures how much of a borrower’s monthly income goes toward all monthly debt payments. This includes car payments, child support payments, alimony payments, minimum credit card, student loan payments, or personal loans – in short, the total monthly debt payments. Living expenses like food and entertainment are not included in the DTI calculation.

In calculating a back-end debt-to-income ratio for a prospective borrower, mortgage lenders want to know how much gross monthly income is going to all debts. In the eyes of a lender, the back-end DTI is the more important of the two debt-to-income ratio measures for someone seeking a new mortgage.

Here’s an example of a back-end DTI calculation:

  • Gross monthly income: $5,800.
  • Student loans: $250.
  • Credit card payments: $300.
  • Car loan: $250.
  • Mortgage: $1,450.
  • Debt-to-income ratio: 38.7%.

To receive optimal borrowing terms for a mortgage or loan, the back-end debt-to-income ratio should be between 30% and 38%. A borrower can still get a mortgage with a back-end debt-to-income ratio of up to 45% or 50%, depending on the lender, but the terms will be more onerous and the interest rate higher.

A lender will typically use the lower front-end and back-end ratios when determining how much house you can afford. The lender estimates the most you can comfortably pay each month, not just toward the mortgage balance itself but also for the other expenses that come with a mortgage, like taxes and insurance.

Lenders like low debt-to-income ratios. The closer both numbers get to the 20% to 30% range and the further from the 40%-plus range, the better the terms one will receive on key things like interest rates.

If you’re worried that investing in real estate with university debt is impossible, don’t fret – income-based repayment or alternative lenders may help.

How Important Is the Debt-to-income Ratio for a Mortgage?

Very! In addition to having a secure job and a good credit score, debt-to-income ratios that fall within the right zones are critical to obtaining a large loan such as a mortgage. If a lender is unwilling to lend you money or meet the size of the loan you’re seeking, you may be able to push the loan across the finish line by having a cosigner on your mortgage documents.

Real estate investors might choose 30-year loans specifically to keep their debt-to-income ratio lower, as 15-year loans have higher monthly payments.

Keep in mind that lenders typically don’t include expenses like health insurance, groceries, and tuition payments in the total debt payment amount. So if you have high expenses, a good DTI ratio may not be as definitive.

Learn More About Debt-to-income Ratio

Use these resources to learn more about the debt-to-income ratio:

Caution: Your Debt-to-Income Ratio Can Make or Break Your Investing Career

Rookie Reply: My Debt-To-Income is Too High to Get Another Property, How Do I Keep Up the Momentum?

Seeing Greene: How Do I Buy Another Property When My DTI is Too High?