When you apply for a mortgage, lenders execute financial calculations to determine whether or not you qualify for a loan. Therefore, you should become familiar with the debt-to-income ratio (DTI) before buying your home. This formula will help you understand what lenders are looking for when approving loans and how to ensure your financial health when taking on a mortgage.
What is the debt-to-income ratio?
The debt to income ratio refers to the percentage of the money you spend compared to your overall household income.
When applying for a loan, you must meet the debt-to-income ratio requirements set by your lender. Lenders require this to be more confident that you won’t take on debt you can’t afford to pay.
Lenders always prefer borrowers with a lower debt-to-income ratio.
Lenders consider two types of debt-to-income ratios during the mortgage process:
Front-end debt-to-income ratio
The front-end DTI includes the expenses related to housing. You can calculate this using your future monthly mortgage payment, including homeowners insurance, homeowners association dues, and property taxes. The front-end figure may also include a mortgage insurance premium depending on your loan.
Back-end debt-to-income ratio
The back-end DTI includes all your minimum monthly debts. The monthly payments include student loans, credit cards, personal loans, and auto loans. The back-end DTI is what most lenders focus on when deciding to give you a loan. It gives lenders a clear picture of what you spend monthly and your ability to meet your monthly expenses.
Calculating debt-to-income ratio
To calculate the debt-to-income ratio, add all of your monthly debt and divide it by your total gross income. The numbers will change depending on whether you use front-end or back-end DTI. Ideally, you will calculate both front- and back-end DTI to give yourself a clearer picture of your financial standing.
Step 1: Calculate your minimum monthly payments
You should include your regular and recurring monthly payments in your DTI calculation. If you are calculating the front-end DTI, add all of your expenses in maintaining your home: homeowner’s insurance, mortgage principal and interest, HOA fees, property taxes, and mortgage insurance premium (if applicable).
For a back-end DTI calculation, you will include all applicable debt payments. These can include but are not limited to: minimum credit card payments, student loan payments, car payments, HELOC (home equity line of credit) payments, etc…
The debts that you should factor into your debt to income ratio include
- Monthly mortgage payments
- Auto loan payments
- Homeowners insurance premium
- Homeowners Association (HOA) fees
- Credit card payments
- Personal loan payments
The expenses that you should leave out of the minimum monthly payment calculations include:
- Health insurance premiums
- Utility costs
- Entertainment, clothing, and food costs
- Transportation costs
- Savings account contributions
- 401 (k) contributions
While you need to factor these expenses into your budget, they are not part of calculating your DTI.
Step 2: Divide monthly payments by the monthly income
The next step in calculating your DTI is dividing the total debts by your monthly income. Make sure you use your gross monthly income. The gross monthly income refers to the total amount of your pre-tax income. Now divide the minimum monthly debt payments by the gross monthly income.
Step 3: Convert it into a percentage
The debt-to-income ratio will be displayed as a percentage. When you divide the monthly payments by the gross monthly income, the result you get will be a decimal. Convert that decimal number into a percentage by multiplying the resulting quotient by 100.
What role does DTI play in the lending process?
Lenders examine your finances when you apply for a mortgage. The finances include monthly gross income, credit history, and what you owe for a downpayment. The debt-to-income ratio is a tool used by lenders to determine if you can afford the house or not.
Lenders prefer a back-end DTI ratio lower than 36% and no more than 28% for the front-end DTI. Financial institutions can accept higher ratios depending on your downpayment, savings, and credit score.
Financial institutions use the debt-to-income ratio to determine your risk as a borrower. A low ratio indicates that you have a good balance of debt and income. A high ratio shows that you have too much debt for your income each month.
The debt-to-income ratio helps lending institutions determine your ability to repay your loan. Borrowers with a high debt-income ratio have a higher chance of experiencing trouble making their monthly payments.
Ways to lower the debt-to-income ratio
If your debt-to-income ratio is higher than recommended, there are ways you can reduce it. Here are some strategies you can apply
- Pay off your smallest debts: One of the fastest ways to lower your DTI ratio is by eliminating monthly payments. If possible, pay off all your smaller outstanding debts.
- Increase your income: This may seem obvious, but increasing income through a side hustle or added hours will help improve your DTI ratio.
- Put someone else on the loan: If you are buying the house with a spouse or partner, the DTI calculation will use the debts and income of you and your spouse or partner. You can add your partner to the loan if their DTI is lower.
Other financial calculations used by lenders
In addition to the DTI, lenders utilize other financial calculations to determine your ability to repay the loan. The calculations are:
- Loan-to-value ratio (LTV): LTV is the ratio of the home loan amount versus the home market value. For example, if the home value is $100,000 and your downpayment is $20,000, the LTV is 80%. In many cases, a lower LTV can result in a lower interest rate since the loan risk is lower.
- FICO score: The score measures how well you have managed your debt payments. Higher scores indicate that you have done an excellent job and consistently paid back your debts.
Your debt-to-income ratio is a vital factor in qualifying for a mortgage. Understanding this calculation will help you get a better idea of your financial situation and how lenders will view your loan application.
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