If you’re in the market for your first home, chances are pretty good that you’re planning on using a mortgage to make the purchase. After all, that’s the strategy that most people use to pay for their home.
As such, you may have been watching your credit score and taking steps to improve it. But while your credit score is an important number that potential lenders will use to evaluate your mortgage application, it’s not the only number that you need to keep an eye on. Another number that potential lenders are going to take into consideration is your debt-to-income ratio.
Below, we define debt-to-income ratio, explain why it’s so important, show you how to calculate it, and offer a few tips that you can use to improve your number.
What is the debt-to-income ratio?
Your debt-to-income (DTI) ratio is a financial metric that quickly shows how much debt you have compared to your income. Lenders use your debt-to-income ratio in conjunction with other metrics, such as your credit score and things like the loan’s principal, interest, taxes you’ll owe, and insurance, to judge the likelihood that you’ll be able to repay the loan.
Your debt-to-income ratio can be represented in two ways: as a front-end ratio or a back-end ratio.
A front-end ratio is meant to show lenders what percentage of your monthly gross income (before taxes and deductions) is dedicated to paying your housing expenses. This would include your mortgage payment as well as any homeowners insurance, property taxes, or other expenses. The front-end ratio is also known as the “housing” ratio.
A back-end ratio, on the other hand, shows lenders what percentage of your monthly gross income is dedicated to paying all of your monthly debt. This includes any car loans, student loans, credit cards, personal loans, and installment debt in your name, as well as the housing expenses encapsulated by the front-end ratio discussed above.
Why is the debt-to-income ratio so important?
If you have a high debt-to-income ratio, you’ll most likely be seen as a riskier borrower since so much of your income is dedicated to servicing your debt. This can limit the amount that you can ultimately get with a mortgage. In extreme cases, a high DTI ratio may even make you ineligible for a mortgage.
On the other hand, if you have a low debt-to-income ratio, you will typically be viewed as a less risky borrower. This can improve your chances of having your mortgage application approved, and it can even increase the amount that you’re approved to borrow.
What is a good debt-to-income ratio?
It’s important to note that your debt-to-income ratio is just one factor that lenders consider as a part of your mortgage application. In reality, your DTI ratio will be considered in conjunction with other factors, such as your credit score. Likewise, all lenders are free to set their own requirements in terms of what they consider an acceptable debt-to-income ratio.
That being said, the Consumer Financial Protection Bureau (CFPB) recommends that homeowners should aim to keep their back-end debt-to-income ratio to 36 percent or less. Most lenders recommend that the front-end ratio should be kept to 28 percent or less. CFPB suggests that renters aim for 20 percent or less, keeping in mind that this does not include rent.
How to calculate your debt-to-income ratio
To calculate your debt-to-income ratio, all you need to do is:
Add together all of your monthly debt payments. This should include your credit cards, student loans, personal loans, auto loans, alimony or child support, and any other debt included in your credit report.
Calculate your gross pay. This is your pay prior to taxes and other deductions.
Divide your total monthly debt (#1) by your gross income (#2) and multiply that number by 100 to convert it into a percentage.
How to improve your debt-to-income ratio
If you run the calculation above and realize that your debt-to-income ratio is too high, you can improve it. Doing so before applying for a mortgage can help you improve your chances of being approved, increase the size of the mortgage that you qualify for, and even lower your interest payments.
First, consider negotiating a lower interest rate with your lenders. Doing so will allow you to pay down your balances more quickly, helping you lower your ratio. If a lender declines, you may also be able to lower your interest rates by refinancing your debt.
You can also lower your debt-to-income ratio by lowering your minimum required monthly payments. This is typically achieved through refinancing. It’s important to note, though, that this will most likely extend the total length of time that you are paying back your debt, which will usually mean you pay more in the form of interest over the life of the loan.
Finally, one of the most straightforward options for lowering your DTI ratio is to simply make extra payments on your debt.
If you are unsure about how to calculate or improve your debt-to-income ratio, a financial advisor can help. In addition to answering your questions, a financial advisor can also help you better understand how a mortgage fits into your entire financial picture.
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