What is 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. In essence, they're a quick way to figure out how much debt you have compared to your gross monthly income.

If your debt-to-income ratio is high, 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 make 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 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 minimum monthly 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 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 really 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 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 debt-to-income ratio?

This 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 monthly income would go toward housing expenses, which include:

  • Principle
  • Interest
  • Property taxes
  • Homeowners 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 percent
Typically, lenders will want to see front-end ratios below 30 percent before approving a borrower for a mortgage. High credit scores and high monthly incomes may make a sub-30 percent less vital.

Some lenders will still approve a loan with a debt-to-income ratio 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 monthly income.

What is back-end debt-to-income ratio?

This ratio 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 and 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 percent
In order to receive optimal borrowing terms for a mortgage or loan, the back-end debt-to-income ratio should be between 30 and 38 percent. A borrower can still get a mortgage with a back-end debt-to-income ratio 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 university debt is impossible, don’t fret: income-based repayment or alternative lenders may be 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 ratio 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.

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

How to lower your debt-to-income ratio

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 monthly 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 debt-to-income ratio.


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Related terms
PITI
PITI stands for principal, interest, taxes, and insurance. Together, these are the elements that make up a conventional loan's mortgage payment.
Reverse Mortgage
A financial agreement in which a homeowner relinquishes equity in their home in exchange for regular payments, typically to supplement retirement income.
Underwriter
In real estate, underwriting is when an individual or business entity seeks funding for a real estate project or purchase and the loan request is scrutinized to determine how much risk the lender is willing to accept. This procedure is performed by an underwriter.