fbpx

What the Debt-to-Income Ratio is and How to Figure it Out

Buying a home can be a thrilling yet stressful process. For first-time homebuyers, there are a lot of new terms to understand before they start looking at homes to buy. One of the most important terms is the DTI or debt-to-income ratio. This number helps mortgage lenders determine if they’re going to offer a loan and how much the loan will be for, so it’s something all homebuyers should be aware of and understand before they start shopping.

What a DTI Is

A DTI shows the percentage of income spent each month out of the total money coming into the home. This number should be as low as possible when applying to a mortgage, as lenders will not want to lend money to someone who has a high DTI, as this is a sign the borrower will be stretched too thin and have trouble repaying the mortgage. The DTI can be a front-end DTI or back-end DTI, and it is a good idea to be aware of both before applying for a home loan.

  • Front-End DTI – The front-end DTI is determined using the potential mortgage payment, property taxes, and homeowner’s insurance instead of current monthly debts. This gives the lender an idea of what the borrower’s DTI would be if they received a mortgage.
  • Back-End DTI – The back-end DTI includes the minimum monthly debts currently being paid. This includes not only housing-related payments but anything else that is paid monthly like personal loans, car loans, and credit cards. This is the main number to be concerned with as it gives the best picture of whether a borrower can afford to pay the mortgage on top of existing bills.

Why the DTI Matters When Buying a Home

Lenders look at the DTI for a homebuyer to make sure they qualify for a loan. The back-end DTI is used to determine if someone can afford to pay the mortgage each month or if they’re going to struggle to afford everything. Lenders will look at the front-end DTI, but the back-end DTI is generally more important as it includes more. It is a good idea to get the number as low as possible, but different lenders will have different maximums for the back-end DTI. Some will require it to be below 36%, while other lenders may accept a DTI of up to 50%. Still, lower is better, as a lower DTI and a higher credit score can lead to a lower interest rate.

How to Calculate a DTI

Before applying for a loan, borrowers can calculate their own DTI and see if there’s anything they can do to improve it. This is a good idea for all borrowers to do. There are a few steps to do this. Add Monthly Minimum Payments – Add up all of the payments that will be applicable in the DTI. For a back-end DTI, this includes a current rent or mortgage payment, car payments, student loan payments, child support or alimony, credit card payments, and anything else that is paid every month. This should not, however, include utilities, entertainment, groceries, or other expenses.

  • Divide by Gross Monthly Income – The number above should be divided by the pre-tax amount of income for one month. The end number will be a decimal, like .45.
  • Make it a Percentage – The decimal can be converted to a percentage by moving the decimal to the right twice. If the minim payments divided by the gross monthly income is .45, the DTI percentage will be 45%. If the number is .346, the DTI percentage will be 34.6%.

After the DTI is calculated, it should give a better picture of whether the borrower can apply for a mortgage or if they should wait and lower their DTI first. If the DTI is high, look into what can be paid off to reduce it. The smaller the DTI, the better, so if it’s possible to get rid of any debts, borrowers will want to do that before moving onto the next step in the home buying process, even if they are below the maximum for the loan.

If you’re planning on purchasing a new home, take a moment to determine your DTI and make sure it is as low as possible. This can help you have a better chance of being approved for a loan and can help you get a better interest rate for the home. If you’re not sure that the DTI is low enough, look into the monthly expenses you have and see how you can reduce them before you apply for a mortgage.

Get a personalized loan consult with one of our experts today.