What is the Debt-to-Income Ratio and Why Does it Matter?
Debt-to-income ratio is the seemingly ‘magical’ formula lenders use to determine if an individual’s monthly income is adequate to live somewhat comfortably, to pay his/her current debts, and to assume a mortgage payment. In other words, DTI determines if you are a safe bet when it comes to loaning you money and if you’re ready to buy a home.
Buying a home is the first step towards getting ahead of peers with real estate, and the first step towards buying a home is getting a mortgage. Getting a mortgage is all about your debt-to-income ratio. The core of DTI are the calculations that describe a person's monthly debt load as compared to their monthly gross income. If your cumulative debts are too high, you should reduce and/or pay off those debts before applying for a mortgage.
Mortgage lenders break Debt-to-Income Ratio into two parts:
- Front-end ratio: This is the percentage of your income consumed by mortgage expenses on the type of home you want to purchase.
- Back-end ratio: This is the percentage of your income consumed by all debt burdens.
In general, to approve a mortgage, most lenders require potential homeowners to maintain a front-end ratio no greater than 28% and a back-end ratio no greater than 36%. This is why the need to pay down and/or off credit card and other debts is often stressed. The lower your front-end ratio, the better your chance of getting a mortgage and a good interest rate.
It should be noted that debt-to-income does not indicate your willingness to make a monthly mortgage payment or mean you can't benefit from buying a home. It only measures a mortgage payment's economic burden on a household.
Click here to calculate your debt-to-income ratio.
How a Good DTI Benefits You
There are 3 reasons:
- Available credit: While suggesting you pay off as much debt as possible in order to acquire a mortgage, acquiring a mortgage adds substantial debt to your DTI. And to add debt, you need good credit. This is why paying your bills on time, or even a day or two early, is so important. The better your credit score, the lower your interest rates will be. This is particularly true for credit cards, and in the end, you will need to furnish your new home.
- Interest rates: Mortgage rates do fluctuate, just not as wildly as credit card interest rates. When you are looking at a $225,000 mortgage over 15 or 30 years, even ¼ of a percent adds up to a lot of money in the long run.
- Home buying potential: How much house can you afford? That seems like a basic question, but it can be mystifying when it comes down to figuring it out. Part of the answer will lie with your mortgage lender – FHA, Fannie Mae, Freddie Mac, a credit union, or a bank. The lower your mortgage interest rate, the more house you can afford if you have a favorable debt-to-income ratio and a sufficient down payment.
How to Improve Your Debt to Income Ratio
Improving your debt-to-income ratio is the key to obtaining a mortgage. Lowing your DTI is necessary and can be done in two ways. First and foremost is to reduce your recurring (monthly) debt and avoid common mistakes with your debt that will make it difficult to get a mortgage.
The other way is to increase your monthly income, which is not always an easy prospect. By this, we are not suggesting you add twenty or more hours to your weekly work schedule! The last thing you want to do is put your regular job in jeopardy.
Is there a second job you could do perhaps on a Saturday or Sunday only? What about freelancing opportunities you could pursue from home on your own time? Thinking creatively about how to increase your income might just turn up some great ideas.
Take time to pay down your debt and increase your income in order to improve your DTI, and you should be able to buy the right home for yourself with no issue. If you’re unsure how to navigate the process, reach out to a real estate agent who can help you with buying a home.