If you’re thinking about taking mortgage loan or buying a house, you need to understand what the debt-to-income ratio means. The DTI is largely a system employed by lenders to assess a borrower’s ability to refund a loan.
Evaluating a borrower’s loan repayment capacity makes the home buying process easy and straightforward. In fact, many lenders target borrowers who have a lower debt-to-income ratio. With a low DTI, your chances of getting that mortgage loan become higher.
But what exactly does this ratio entail? This post will enlighten you on the basics of the debt-to-income ratio and how you can maximize this personal finance measure. You’ll learn how to calculate the DTI and how to determine the best ratio for a mortgage or house.
What is the Debt-to-Income Ratio?
When applying for credit, your debt-to-income ratio becomes important. The DTI is essentially a reflection of your financial health in terms of debts and gross monthly income. Before you consider taking or applying for a loan, you should grasp the truth of your debt situation and what it means to lenders.
The debt-to-income ratio is a percentage derived from calculating your monthly debt payments and your gross monthly income.
- Your monthly debt includes the payments you have to make on a monthly basis.
- Your gross monthly income involves your total earnings per month before the deduction of taxes and other payments.
When you compare your debt payments and income every month, the percentage that goes to debt payments is your debt-to-income ratio.
This personal finance tool is especially important because it enables you to make informed decisions about your finances. In terms of loan taking and debt payments, the DTI is structured to empower you to approach lenders including mortgage lenders with confidence.
When you can provide evidence that you’re efficiently managing your monthly debt payments, lenders will be willing to offer you a new loan.
The Debt-to-Income Ratio Definition
A notable definition of the debt-to-income ratio is the percentage of your debts in comparison with your monthly income. The percentage you assign to paying debts or servicing loans is your DTI. Creditors (big or small) take this into consideration before granting a loan to a potential borrower.
As a borrower, your goal should always be to maintain a low debt-to-income ratio. Most lenders set the maximum ratio at 43%. This is a good enough indicator that a potential borrower is efficiently managing his debts. With 43%, you get to qualify for a mortgage without stressing about how the loan repayment will affect your income or lifestyle.
Despite the fact that the highest DTI ratio is 43%, the alternative preference of some lenders is 36% or less. With a debt-to-income ratio that’s lower than 36%, lenders can trust borrowers to refund their loan within the defined period.
What is Included in the Debt-to-Income Ratio?
For the lender, the front-end/housing ratio and the back-end ratio are significant. While the housing ratio evaluates the percentage of your monthly income which goes to housing expenses such as rent, taxes, and dues, the back-end ratio considers the ratio needed to pay all you owe, including credit card payments and other loans.
For the borrower, three key factors are involved in the debt-to-income ratio. These include:
- Gross Monthly Income
- Monthly Debt Payment
- Lender’s Preferred DTI
On the one hand, the full pay you receive per month is your gross monthly income. On the other hand the percentage of this amount which goes to servicing debts is your debt-to-income ratio.
Let’s say you earn $5,000 as gross monthly income. You pay $1,200 for mortgage monthly, $200 for your car loan, and $600 for other debts. The total of your debts payments for a month is $2,000. Your DTI, therefore, becomes the percentage of $2,000 divided by $5,000 which is 40%.
However, a third and most important aspect of this ratio is the lender’s preferred DTI. Most lenders prefer a low debt-to-income ratio as it is sufficient proof that a potential borrower is trustworthy in terms of the new credit to be issued.
For one, banks and several credit providers are skeptical about borrowers with high debt-to-income ratio. Ratios which exceed 43% often signal a poor balance between a person’s monthly debts and income. And when questions are raised about your ability to pay a loan, your loan request might never be considered.
More important is the fact that while the generally acceptable debt-to-income ratio is 43%, some credit providers operate a different ratio. What this means is that you need to find out your proposed lender’s maximum DTI before making any conclusions.
How do you calculate the Debt-to-Income Ratio?
From the illustration above, you understand that the debt-to-income ratio is the percentage that expresses your monthly debts in light of your monthly income.
So, we’ll consider this example. Smith intends to get a loan and he’s trying to understand his DTI.
- He earns $5,000 as gross monthly income
- He pays $1,200 for mortgage loan
- For his car loan, he pays $200
- Other small loans including credit cards, student loan, and rent take $600
Doing the math, you see that Smith pays a recurring monthly debt of $2,000 ($1,200 + $200 + $600).
The formula to calculate his debt-to-income ratio is
Recurring Debt Payment / Gross Monthly Income
Step 1: Smith uses this formula and gets:
$2,000/$5,000 = 0.4
Smith’s debt-to-income ratio is 0.4. The next step is to
Multiply the ratio by 100
He gets 40%. He smiles to himself because this ratio is just under the general DTI maximum ratio. So, he’s somewhat confident that his credit provider will consider his loan application and probably offer him the loan for the new project.
What is a Good Debt-to-Income Ratio?
The ideal debt-to-income ratio is defined by the lender in question. Typically, big credit providers prefer the ratio between 28% and 36% as this range is a good indicator of a low-risk borrower. As a matter of fact, the Federal Reserve set 40% as the maximum DTI ratio.
Although the maximum ratio is 43%, some lenders still go as high as 50% or more. The difference is mainly between personal loan providers and mortgage lenders. While personal credit providers can accept up to 50% debt-to-income ratio, mortgage lenders often need to see a low DTI before issuing a loan.
Since the concept of a “good debt-to-income ratio” is dependent on the lender, how can you improve your ratio?
- Increase your gross monthly income
- Reduce your monthly expenses
- Don’t take a new loan until one or more have been paid in full
- Pay off one or more of your debts
These four tricks will help you lower your debt-to-income ratio and raise your chances of getting a new loan.
The main idea is to always keep a low debt-to-income ratio.
What is the Debt-to-Income Ratio to Qualify for a Mortgage?
To qualify for a mortgage, you need to have a DTI ratio that’s lower than 43%. The best ratio is 36% or lower. This implies that you can manage your old debts as well as new ones. In times of financial crisis, a low DTI ratio signals that you can effectively pay what you owe, take care of monthly expenses, and save or invest.
Maximum Debt-to-Income Ratio for Mortgage
Generally, lenders prefer to see a low debt-to-income ratio before considering a borrower’s loan application. In this case, low refers to 28% with a maximum of 43% of your monthly income.
Anything above this ratio gives the impression that your available income is insufficient to meet your monthly expenses and service your loan.
Alternatively, a high debt-to-income ratio proves that you cannot handle your mortgage payments. No lender will be enthusiastic to give you a mortgage. So you should thrive to keep a low DTI (preferably less than 36%). This will help you to get a better pitch with mortgage lenders.
What is the Debt-to-Income Ratio to Buy a House?
Before you buy a house, find out if you’re creditworthy and ready for a loan. To take a loan for a home purchase, you need a debt-to-income ratio of 35% or less.
While some argue that a 50% ratio or more could still be considered, it’s a fact that the higher your DTI ratio, the more difficult it will be for you to repay the loan. And when the greater portion of your income goes to paying debts, living a comfortable life may become impossible.
Hence, before you decide to buy that new home, give yourself time to pay off old debts or find a way to increase your income. Your goal should be to reduce your debts so that your monthly income can create room for more loan payments, if that’s what you choose.
Wrapping Up
Overall, this post has addressed the benefits of using the debt-to-income ratio. This personal finance metric enables you to determine your current financial situation in light of debts and income.
When you know what percentage of your monthly incomes goes to paying loans, and you keep this percentage low, you can approach lenders with positivity.