As you embark on your journey to purchase or refinance a house, you must know your specific debt-to-income ratio (DTI). If your personal debt level is already relatively high compared to your monthly gross income, purchasing a home could be risky.
Even if you are ready to take the risk, you may have trouble finding a lender willing to work with you. Read our detailed guide to learn more about DTI ratios, their importance, how to calculate them, and what is considered a good DTI for a mortgage in 2021.
- The majority of lenders prefer individuals with low debt-to-income ratios over those with high DTI figures. This is because lenders believe that borrowers with low DTIs are better positioned to manage regular monthly mortgage payments.
- Each lender has its specific DTI requirements. Generally, borrowers should have a DTI ratio of 36% or lower.
- Borrowers with a high DTI are likely to be accepted by personal loan providers compared to mortgage lenders.
- Paying off pending debts and cultivating a smart saving habit can help borrowers reduce their debt-to-income figures over time.
What is debt-to-income ratio?
Your debt-to-income ratio is a metric used by loan providers to calculate the percentage of your monthly gross income you must spend on your monthly debts plus the proposed mortgage payments on the new home loan.
In a nutshell, your DTI ratio is how much money you spend on your monthly debts versus the amount of money coming into your household. While you may have a good credit score and stable employment, if your DTI is on the high side, you may end up not getting a mortgage.
For example, a DTI figure of 28% reveals that 28% of a borrower’s monthly gross income is used to pay several debts each month. While most lenders have a defined DTI requirement, borrowers should have a DTI ratio of 36% or lower.
Front-End vs. Back-End Ratios
There are two main types of debt-to-income ratios. They include:
1. Front-End Ratio
Your front-end ratio is the percentage of your income that goes towards your housing-related expenses. Typically, your front-end ratio is the summation of your rent, mortgage payments, property taxes, homeowner’s insurance, homeowner’s association (HOA) fees.
2. Back-End Ratio
Your back-end ratio reveals how much of your monthly gross income would be needed to service all your recurring monthly debt obligations. In addition to the housing-related expenses listed above, your back-end ratio includes debts like credit card debts, student loans, auto loans, child support, and other personal loans. Living expenses are not included when calculating this ratio.
When applying for a mortgage, the back-end ratio is usually considered the debt-to-income ratio. However, most lenders evaluate both ratios when assessing a borrower’s loan application and DTI.
How to calculate your debt-to-income ratio
Before applying for a mortgage, you should consider calculating your debt-to-income ratio. Knowing how to calculate your DTI ratio helps you put your finances in order before applying for a home loan.
Calculating your front-end ratio
Add up your monthly housing expenses, divide it by your gross monthly income, and multiply by 100. For example, John earns a gross income of $6,000 a month and has a total housing expense of $1,800; what is his front-end ratio?
- Gross Income: $6,000
- Total Housing Expenses: $1,800
- So, $1,800 divided by $6,000 = 0.3
- Then you multiply, 0.3 * 100 = 30%
- John’s Front-End Ratio is 30%.
Calculating your back-end ratio
To find your back-end ratio, you add up your monthly housing expenses plus your housing expenses and divide the sum by your monthly gross income.
Let’s continue with our above example.
John receives a monthly gross income of $6,000, pays $1,800 for housing expenses, and has the following monthly debt payments.
- Car loan: $500 per month
- Student loans: $150 per month
- Credit card bills: $200 monthly
Therefore, $1,800 (housing expenses) plus $850 (monthly debt payments) equals $2,650 in total monthly debts.
Based on John’s expected monthly gross income of $6,000, his back-end ratio will be $2,650 divided by $6,000 multiplied by 100. This gives John a back-end ratio of 44%.
What’s an ideal DTI ratio for a mortgage?
The choice of an ideal debt-to-income ratio for a mortgage is highly dependent on the lender, type of loan, and other mortgage requirements. However, most lenders prefer borrowers with a front-end ratio of not more than 28% and a back-end ratio not higher than 36%. In most cases, you will need to have a DTI score of not more than 50% to qualify for a home loan.
DTI ratio requirements for major mortgage programs
FHA loans are backed by the US Federal Housing Administration and offer a more lenient credit score requirement. FHA loans typically require borrowers to have a maximum DTI score of 57% or lower.
USDA loans can only be used to purchase or refinance homes situated in rural areas. To qualify for a USDA loan, borrowers are expected to have a DTI ratio of less than 41%. In addition, your adjusted household income must not exceed 115% of the median income in your specific location.
Insured by the Department of Veteran Affairs, VA loans are targeted at offering low-cost mortgage loans to past and present US armed forces members. One of the upsides to VA loans is that it does not require a down payment. In some cases, you can get a VA loan with a DTI ratio of up to 60%.
There is no specific ideal DTI ratio that fits all mortgage situations when it comes to conventional loans. DTI requirements are typically tailored based on a borrower’s mortgage situation, type of loan, and lender. However, you’ll need to have a DTI of 50% or less to be eligible for a conventional loan.
How to lower your DTI?
If your debt-to-income ratio is relatively high, below are some strategies you can employ to lower it before applying for a mortgage.
Raise your income
Adding an extra source of side income, picking some extra few hours at your current job, or venturing into freelancing can offer you more cash to lower your DTI. However, you’ll need to prove to your lender that the income is regular.
Pay down any existing debt
Make a list of your recurring monthly debt payments. Which of your monthly debt requires the highest monthly payment? Now, pay off those sets of debts before others to lower your DTI and credit utilization ratio. You can also use a debt snowball calculator to determine what debts to settle first and the amount of interest saving you will be making.
Extend the duration of your loan
Extending the duration of some of your loans can go a long way in reducing your monthly payment on the debt. However, you may be faced with a higher interest rate. If you do not have a stable income, this may not be a great option.
Establish a budget
When looking to reduce your DTI ratio, the first step is to create a budget to help you identify areas where you can cut back and save more money. By creating a budget, you can easily channel money that would have been spent on frivolities to settling your existing debts.
Your debt-to-income ratio is a deciding factor when it comes to qualifying for a home loan. It is one of the many ways lenders use to gauge your ability to repay the loan. A DTI ratio of 50% or lower should give you access to multiple loan options when you’re looking to get a loan.
More importantly, if your DTI score is on the high side, you can reduce it by paying down your credit card debts, raising your income, or putting another person (spouse or partner) on the loan application.
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Elijah O. Agor, CFP
Elijah O. Agor is a real estate, 1031 exchange, and mortgage writer. He is a certified financial planner, former loan originator, and chief realtor for Dsquared Realty. In the past, Elijah advised first-time and seasoned home buyers on real estate and mortgage decisions in the Greater Atlanta area. Since hanging up (burning) his suits and ties, Elijah now works to make mortgage and real estate topics understandable and jargon-free.