What Is a Debt-to-Income Ratio?

Debt-to-income (DTI) calculations determine the ratio of a consumer’s current or future monthly debt obligations to their pre-tax, or gross, income. These ratios are almost exclusively used by lenders during the home-buying process, but will also be considered when taking out auto loans or other large loan. They calculate buyers’ debt-to-income ratios to determine if they can financially bear the new loan’s monthly payments. 

If your DTI is high, it means you are highly leveraged and have tight finances, which, naturally, is considered risky from a lending standpoint. On the other hand, if your DTI is low, the lender knows you have plenty of room in your monthly budget to absorb unexpected expenses and still make your mortgage payments.

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 know where you stand. To do this, simply tally up your total monthly debt obligations and divide by your gross monthly income, as follows:

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 bills, phone, cable, or any other regular payments.

Tally up your payments for all debts, including auto 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 five percent 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 debt obligation figure 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 really no way to determine your qualifying income definitively without tax returns.

Keep in mind that when you're qualifying for a home loan, your qualifying DTI 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 DTI when you apply for a loan. There are two different ratios they might calculate: the front-end debt-income ratio and the back-end debt-income ratio.

What Is the Front-End DTI Ratio?

The front-end ratio 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 income would go toward:

  • Principle
  • Interest
  • Property taxes
  • Homeowners insurance

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

  • Monthly gross income: $5,800
  • New mortgage payments: $1,450
  • Debt-to-income ratio: 25 percent

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

Some lenders will still approve a loan with a DTI over 34 to 36 percent, 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 loan or auto loan, then lenders may instead calculate the borrower’s current rent payment in relation to gross monthly income.

What Is a Back-End DTI Ratio?

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

In calculating a back-end DTI 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 DTI 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 payment: $250
  • New mortgage payments: $1,450
  • Debt-to-income ratio: 38.7 percent

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

A lender will typically use the lower of 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 to 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 percent range and the further from the 40 percent-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 student loans is impossible, don’t fret: income-based repayment or alternative lenders may be help.

How Important Are Debt-to-Income Ratios for a Mortgage?

Very! In addition to having a secure job and a good credit score, DTI 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 co-signer on your mortgage documents.

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

How Can I Lower My DTI?

Quite simply, reduce your monthly debt payments. This is obviously easier said than done, especially for someone who is saving up to buy a home. You’re already trying to save up cash for a down payment and closing costs, so trying to reduce credit card balances can be tricky, but this is the only real place to attack your debt. Consider debt consolidation, which can decrease your overall monthly payments.

If you have a chunk of money you’re saving for a down payment, it may be beneficial to use some to pay off credit card debt—especially if you are near the key percentage thresholds on your DTI.

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Related terms
Mortgage
A mortgage is a legal agreement by which a bank or other creditor lends money at interest in exchange for taking title of the debtor's property, with the condition that the conveyance of title becomes void upon the payment of the debt.
Freddie Mac
Federal Home Loan Mortgage Corporation (Freddie Mac) A private corporation founded by Congress, the Federal Home Loan Mortgage corporation's mission is to promote stability and affordability in the housing market by purchasing mortgages from banks and other loan makers.
Hard Money Loan
Hard money is a way to borrow without using traditional mortgage lenders. Loans come from individuals or investors who lend money based (for the most part) on the property you’re using as collateral and not based off of credit scores. When loans need to happen quickly, or when traditional lenders will not approve a loan, hard money may be the only option.