If you're in the market to buy a house, you will most likely hear this term.
So what Is Debt-to-Income (DTI) Ratio? And how do you figure what your ratio is?
The debt-to-income (DTI) ratio is a personal finance measure of the percentage of your gross monthly income that goes to paying your monthly debt payments. It is used by lenders to determine your borrowing risk.
Understanding the term Debt-to-Income (DTI) Ratio
A low debt-to-income (DTI) ratio tells a lender that the client has a good balance between their debt and their income. In other words, if your DTI ratio is 14%, that means that only 14% of your monthly gross income goes to paying off your debts each month. On the flip side, a high DTI ratio can send a red flag that the client has way too much debt for the amount of income they earn each month. You don't want to be in this category, especially when trying to buy a home.
Typically, people with low debt-to-income ratios are likely to manage their monthly debt payments effectively on their own. These are people that are savers, not spenders. As a result, banks and financial credit providers want to see low DTI ratios before issuing loans to a potential borrower. The preference for low DTI ratios makes sense since lenders want to be sure the client isn't overextended. If you are overextended, that simply means that you have too many debt payments relative to the income coming in.
As a general guideline, 43% is typically the highest DTI ratio a borrower can have and still get qualified for a mortgage. Ideally, lenders prefer a debt-to-income ratio lower than 36%. However, these ratios differ from lender to lender. You can check with a couple different lenders to see who you can work with. Regardless of the lender, the lower your DTI ratio, the better chances you have to get approved.
The debt-to-income (DTI) ratio compares your monthly debt payments to your monthly gross income. Your gross income is your pay before taxes and any other deductions that are taken out. The debt-to-income ratio is the percentage of this gross monthly income that goes to paying your monthly debt payments.
So let's figure out how to calculate this DTI ratio.
First, sum up your monthly debt payments including credit cards, car loans, student loans and any other loans as well as your current mortgage or rent.
Find out what your gross monthly income is. Find this on your pay stub.
Now, divide your total monthly debt payment amount by your monthly gross income.
The result will yield a decimal, so multiply the result by 100 to achieve your DTI percentage.
Note that DTI ratio does not distinguish between different types of debts that you may have or the cost of servicing those debts. Credit cards typically carry a much higher interest rate than student loans, but they're lumped in together in the DTI ratio calculation, for example. If you transferred your balances from a high-interest rate card that you have to a lower interest rate credit card, your monthly payments would decrease. As a result, your total monthly debt payments and your DTI ratio would decrease, but your total outstanding debt would remain the same.
Debt-to-Income Ratio Example with numbers.
Bob's monthly bills and income are as follows:
current mortgage: $1,000
existing car loan: $500
various credit cards: $500
Bob's total monthly debt payment is $2,000:
Let's assume his gross income is: $6,000
$2000 / $6000
DTI ratio is 0.33:
To get it to a percentage, multiply by 100. So the DTI percentage is 33%.
So how can you Lower your Debt-to-Income Ratio?
One way to lower your debt-to-income ratio is by reducing your monthly recurring debt. Another way is by increasing your gross monthly income (yeah, ask for that raise!). Or a combination of both.
In the above example, if Bob had the same recurring monthly debt of $2,000 but he was able to switch jobs and his pay increased as a result, and his gross monthly income goes up to $8,000, his DTI ratio calculation will change to $2,000 ÷ $8,000 for a debt-to-income ratio of 0.25 or 25%.
However, if his income stays the same at $6,000, but he is able to pay off his car loan, then his monthly recurring debt payments would drop to $1,500. Bob's DTI ratio would be $1,500 ÷ $6,000 = 0.25 or 25%.
A low debt to income ratio, along with a high credit score and a 2+ year work history are three important factors when trying to get a mortgage with a good rate.
Also, hold off buying that car or all that furniture until after you close on your new home. :)
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