What’s Your DTI? No, It’s Not a Disease
Understanding Your Debt-To-Income Ratio and Why It Is Important
You have probably heard the term “debt-to-income ratio” (DTI) before (or maybe you have not, and that is okay), but what does it actually mean? And more importantly, how does it impact your ability to get a mortgage? DTI is a pretty straightforward concept, but it’s one that a lot of people are not aware of. In this blog post, we are going to break down DTI and explain why it is so important to have a low DTI ratio when you’re trying to get approved for a mortgage.
Why is DTI Ratio Important?
Lenders use your DTI ratio (debt-to-income ratio) as a way to gauge your ability to make monthly mortgage payments. A high DTI ratio indicates that you’re using a large portion of your income to pay down debts, which means you might have difficulty making your mortgage payments if interest rates were to rise or if you were to lose your job. A low DTI ratio, on the other hand, indicates that you have enough disposable income each month to comfortably make mortgage payments even if something unexpected were to happen.
Your DTI ratio is the percentage of your monthly income that goes towards paying down debts — including your mortgage, credit cards, student loans, etc. Lenders use this number to gauge your ability to make timely payments on a new loan. The lower your DTI ratio, the more likely you are to get approved for a mortgage. In general, most lenders like to see a DTI ratio of 36% or less, but most will allow approximately 43–45%. However, some government-backed loans (like FHA loans) allow for higher ratios in certain circumstances. Just remember, even though you may qualify with a higher DTI ratio, the goal is to consistently keep it low to ensure your money is working for you instead of maintaining high levels of debt.
I do not know about you, but I am super visual. So, lets put some of these terms into a practical example. Let’s say your monthly income is $5,000 and your total monthly debt payments are $1,500. Your DTI ratio would be 30% ($1,500/$5,000). If you are looking to get approved for a $225,000 loan with a 6% interest rate and 30-year term, your monthly mortgage payment would be $1,348 — leaving you with plenty of room to make your other debt payments on time each month.
But, what if your DTI ratio is too high? Let’s say you’re still bringing in $5,000 each month, but now your total monthly debt payments are $2,000. Your DTI ratio would be 40% ($2,000/$5,000), which is above the 36% threshold that most lenders like to see. In this case, you might have difficulty getting approved for a mortgage — or if you are approved, it will likely come with a higher interest rate and/or shorter loan term. Again, if you are hovering around the 40% DTI threshold it does not mean you will not get approved, but it could lead to higher payments due to the increased risks to the lender. So, always strive to keep your DTI as low as possible.
How Lenders Calculate Your DTI Ratio
Lenders typically use two different methods to calculate your DTI ratio: the front-end method and the back-end method.
The front-end method simply takes your proposed housing expenses (i.e., your mortgage payment, property taxes and insurance) and divides it by your gross monthly income (i.e., the amount of money you bring in before taxes and other deductions are taken out). So if your gross monthly income is $5,000 and your proposed housing expenses are $1,500, then your front-end DTI ratio would be 30%.
The back-end method looks at all of your monthly debts (i.e. housing expenses, in addition to credit card payments, student loans, car payments, etc.) and divides it by your gross monthly income. So using the same numbers from above (monthly income of $5,000 and total monthly debt payments of $2,000), we get a back-end DTI ratio of 40%.
As you can see from these few examples above, having a low DTI ratio is key to not only getting approved for a mortgage, but having the disposable income to build wealth in general. From a mortgage perspective alone, this is why it is important to understand how lenders calculate this number. If you are not sure what yours is or whether or not it’s high enough to qualify for a loan amount that you’re comfortable with, it is important to speak to a loan officer to determine where your DTI currently stands if you are looking to buy a home. The more information and education you have, the easier it will be to take these wealth building steps. Think of it as a compass. Without it, it is difficult to know where you are going or where you will end up! Use the resources around you to continuously act as a guide for your financial endeavors.
*This is not financial advice. For educational purposes only. Before making any financial decisions, consult with a professional.