What Is Debt-to-Income Ratio?
Debt-to-income ratio is an important factor that lenders use when determining your home loan application.
If you’re in the homebuying market, you’ve probably heard the phrase “debt-to-income ratio” thrown around. Whether you’re a first-time homebuyer or just brushing up on your financial savvy, it’s important to understand what this phrase means.
Your debt-to-income ratio (or DTI) is a financial measure that’s used by mortgage lenders and others to assess your financial health and determine how much mortgage you can afford.
It might seem confusing at first, but knowing your DTI is the first step toward ensuring you’ll be able to manage a mortgage and keep up with payments while still setting aside enough money for your other needs.
How Is DTI Calculated?
DTI is expressed as a percentage, which is calculated by dividing your total recurring monthly debt by your monthly gross income.
Monthly debt should include ongoing loans such as your rent or mortgage, auto loans, personal loans, credit cards, alimony or child support and student loans. It does not include living expenses like groceries or utilities. Monthly income should include your entire household’s salaries or wages before tax.
Here’s an example:
- Total monthly debts are $300 (auto loan) + $200 (student loans) + $1,000 (mortgage) = $1,500
- Total monthly gross income = $4,500
- $1,500 / $4,500 = 33.33
- This household’s DTI is 33%.
To try it yourself, plug in your potential mortgage payment with your other monthly debts and see what your DTI would be. (Be sure to omit your rent payment in your calculation, as you will only be making one housing payment in this scenario.)
When making your calculations, remember to include all applicable costs in your mortgage payment estimates. This includes the interest and principal, as well as property taxes, homeowners insurance, private mortgage insurance, and any potential condo or homeowners association fees.
What Should Your DTI Be?
In reality, the lower your DTI, the better. Under 36 percent DTI is preferred, with no more than 28 percent of that debt going toward your mortgage.
- 35 percent or less – You’re in a good place financially. Keep it up!
- 36 percent to 43 percent – You’re doing fine but may want to look at ways to reduce your debt.
- 44 percent or higher – You’re spending almost half your income on debt and need to take action.
Ways to Improve DTI
Improving DTI is simple in theory but something that will take time and effort. There are two ways to improve your DTI:
- Lower your debt
- Increase your income
Depending on what type of debt you have, you could consider debt consolidation. This is when you take several loan balances (e.g., credit cards, personal loans) and roll them into one monthly payment, usually at a lower interest rate. Debt consolidation can help you streamline your balances to pay them off quicker.
Look at other ways to be frugal, too, such as keeping an older car for longer instead of buying a new car. Decisions like these that affect your DTI and credit score are especially important as you’re gearing up to buy a home.
To increase your income, you might want to consider an additional part-time job, renting out a spare room in your home, or asking for a raise at your current job. Evaluate your situation to determine what opportunities make sense for you.
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