Calculating your debt-to-income (DTI) ratio is a crucial step in determining your financial health, especially when it comes to applying for a mortgage. In addition to your credit score, your DTI gives mortgage lenders insight into your ability to handle mortgage payments along with your existing debt.
By understanding your DTI ratio, you can determine how comfortable you are with your current financial situation and decide if applying for credit is the right choice for you. Let’s dive into how you can calculate your own debt-to-income ratio and what it means for mortgage lenders.
What is the debt-to-income ratio?
Lenders use your debt-to-income ratio (DTI) to assess your borrowing risk when applying for a mortgage. Your DTI is the percentage of your gross monthly income (before taxes) that goes towards debt payments such as rent or mortgage payments, credit card balances, and auto loans.
A high DTI, meaning a large portion of your income goes towards debt payments, may make lenders hesitant to work with you. This is because there is a greater chance of you being unable to repay your loan if you have too many significant debt payments.
How to calculate your debt-to-income ratio
Calculating your debt-to-income ratio (DTI) is a crucial step before applying for a mortgage, and it’s easy to do. Follow these simple steps to calculate your DTI:
- Add up all your monthly debt payments: This includes your rent or mortgage payments, personal loans, auto loans, student loans, credit card payments, child support or alimony payments. If you’re applying for a mortgage with someone else, be sure to include their debts as well. But don’t include other monthly expenses like food and utilities.
- Divide your total monthly debt payments by your monthly gross income: Next, divide your debt payments by your pre-tax monthly income. This will give you a decimal number. Remember to use the combined debts and income of all mortgage applicants.
- Convert the decimal number into a percentage: To do this, multiply the decimal number by 100. The resulting number is your DTI percentage. The lower your DTI percentage, the less risky you are to lenders.
Here’s an example: A borrower with rent of $1,350, a car payment of $250, a minimum credit card payment of $300, and a gross monthly income of $5,000 has a debt-to-income ratio of 38%.
How lenders evaluate your DTI
When you apply for a mortgage, the lender will look at your debt-to-income ratio, or DTI, as a critical evaluation point. Even if you have a good credit score and steady income, if you already owe a lot of money, the lender might not think you’re financially secure enough to add a mortgage to your monthly debt payments. That’s why it’s important to know your DTI ratio before applying for a mortgage.
Generally, lenders prefer a DTI ratio lower than 43% to qualify. But ideally, lenders prefer a debt-to-income ratio lower than 36%, with no more than 28% of that debt going towards housing expenses. Some lenders may allow DTIs up to 50%, if you have some compensating factors, however, lower is better.
Ultimately, the maximum DTI ratio varies among lenders and loan programs. However, the lower your debt-to-income ratio, the higher your chances of getting approved for a mortgage.
Bottom line
As a potential homebuyer, you should know that your debt-to-income ratio is an important factor that lenders consider when reviewing your mortgage application. Your DTI gives lenders an idea of your current financial situation and helps them decide if you can manage a mortgage along with your existing debts.
To improve your chances of getting approved for a mortgage, try to pay down your debts and increase your income. Understanding your DTI and taking steps to improve it can help you achieve your dream of homeownership.
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