What is Debt-to-Income (DTI) Ratio?

As of 2020, approximately 44 percent of U.S. consumers had a mortgage. If you are thinking of taking out a loan to buy a house, you should first understand the basics of mortgages. Apart from your credit score, another important number that can get in your way of qualifying for a home loan is your debt-to-income ratio. This ratio is used to determine whether you can afford to repay the loan. But what exactly is debt-to-income ratio and why does it matter? 

What is Debt-to-Income Ratio?

Debt-to-income ratio, or DTI, is simply the percentage of your gross monthly income that goes towards paying your monthly debts. Your gross monthly income refers to the total income you receive from all sources before any taxes or deductions are taken out. On the other hand, your debt expenses may include monthly credit card payments, mortgage payments, car payment, student loan payments and personal loan payments. 

This ratio compares your debt and income, making it a critical part of your overall financial health. Generally, a low DTI shows that you can comfortably meet your debt obligations while a high DTI is an indication that you have too much debt for the amount you earn each month. 

DTI enables lenders to measure whether you can afford another monthly payment, effectively helping to establish your level of risk as a borrower. There are two main types of debt-to-income ratios: front-end ratio and back-end ratio. 

How to Calculate Your DTI Ratio

Before applying for a loan, it is important to know your debt-to-income ratio. This will require that you learn how to calculate the ratio. Below are the steps to follow.

1. Start by adding up all your monthly debts. The payments may include:
2. Monthly rent or mortgage payment
3. Monthly student, auto and personal loan payments
4. Credit card monthly payments
5. Monthly alimony or child support payments
6. Other debts that show on your credit report
7. Divide the sum of your monthly debts by your gross monthly income.Convert the figure into a percentage. The result is your debt-to-income ratio.

Alternatively, you can use a debt-to-income ratio calculator to compute your DTI. When calculating your DTI, financial obligations and monthly bills like groceries, utilities, daycare expenses, healthcare expenses and insurance premiums are not considered part of your debt expenses. As such, qualifying for a certain loan amount does not necessarily mean that you can afford the associated monthly payments. Before taking on new debt, you should take your overall budget into account to determine whether you are financially comfortable. 

What is an Ideal DTI Ratio?

Generally, you should keep your DTI ratio as low as possible. A low DTI will demonstrate that you have a good balance between debt and your earnings, and that you will manage to make the monthly payments that come with a loan. This will increase your chances of being considered and getting approved for a loan, and help you argue for a better interest rate. But what exactly is a good debt-to-income ratio?

Typically, a good debt-to-income ratio is 36 percent or less. Oftentimes, lenders will prefer a situation where no more than 28 percent of the debt goes towards servicing a rent or mortgage payment. Although the maximum DTI ratio varies from lender to lender, the highest a borrower can have and still qualify for a home loan is under 57% for an FHA loan and under 50% for a Conventional loan.

Why is DTI Ratio so Important?

There are many reasons why you should keep an eye on your DTI. This number is an important metric that can provide information about your financial situation. Here is why you need to keep your DTI ratio at a reasonable level. 

Helps You Qualify for Loans

Most financial lenders will look at how much debt you can take on before you start experiencing financial difficulties. In addition to your credit score, lenders will use your DTI ratio to assess your creditworthiness and determine whether you qualify for a loan. Keeping your debt-to-income ratio low will help you qualify for loans and enjoy excellent terms on the loans. 

Improve Your Financial Health

It is not just lenders who benefit from knowing your DTI. Your debt-to-income ratio will help you know whether your debt is getting out of control. This way, you will be in a better position to make sound decisions and keep your debt at a manageable level. In the end, you will avoid financial stress and enjoy peace of mind. 

When your debt-to-income ratio is too high, your financial life will be affected in several ways. It will be more difficult for you to qualify for home loans, and you will have less favorable terms when you borrow. Also, when a significant percentage of your income goes towards debt payment, you will struggle to pay off debt and have less flexibility in your budget. 

How to Improve Your Debt-to-Income Ratio 

There are several steps you can take to reduce your debt-to-income ratio when it is too high. However, improving your DTI ratio will require strategic planning and financial discipline. Below are a few things you can do. 

Decrease Your Debt Burden

Paying off your debts aggressively will help to reduce the amount you owe over time. Increasing the amount you pay monthly will enable you to lower your overall debt faster, eventually bringing your DTI to a manageable level. 

Increase Your Monthly Income

Increasing your income is a great way to reduce your DTI to a comfortable level. When you earn more, you will be able to pay off your debts faster without straining. To increase your income, consider building a passive income stream, getting a part-time job, starting a side hustle or getting a better paying job. 

Avoid Taking on New Debt 

As you work towards reducing your debt-to-income ratio, you should avoid taking on more debt. Postpone any large purchases, avoid bad debt and handle your finances responsibly. This will allow you to focus on reducing the existing debt. 

Knowing about DTI can help you prepare for a home loan when the time comes. You will also need to compare the various loan options available and choose the best mortgage lender for your needs. I am committed to helping you find the right loan for your situation at the best rate possible. Schedule a FREE Consultation today to learn more.