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Debt-to-Income Ratios

A debt-to-income ratio (DTI) is the relation of how much debt you have vs your total household income as a percentage. A lower percentage rate reflects that you are a stronger borrower versus the opposite. Lenders and creditors review your debt to income ratio as a measure of your ability to manage your monthly debts.

KEYNOTES

  • Mortgage lenders prefer low debt-to-income (DTI) figures because they often believe these borrowers with a small debt-to-income ratio are more likely to successfully manage monthly payments.
  • Credit utilization impacts credit scores, but not debt-to-credit ratios.
  • Creating a budget, paying off debts and making a smart saving plan can all contribute to fixing a poor debt-to-credit ratio over time.

Understanding Debt-to-Income Ratio

A low debt-to-income ratio shows good management between your debt and income. In general, the lower the percentage, the better the chance you have to get the loan or line of credit that you want.

On the contrary, a high debt-to-income ratio reflects that you may have too much debt that you can handle with your income that you have. Lenders view this as an indication that you might not be able to take on any additional debts.

How to Calculate Your Debt-to-Income Ratio

There are 2 parts to the Debt to Income Ratios.  There is the Front-end and the back-end ratios. The front-end ratio shows the relation of your housing expense vs your gross monthly income.  The back-end ratio shows the relation of your housing expense and your total monthly debt vs your gross monthly income.  Both numbers are expressed as a percentage.

Front-End Ratio

Debt-to-Income Ratios Unlimited Mortgage LendingThe front-end ratio is calculated by taking your present rent and dividing it by your gross monthly income times 100.  If you had a mortgage payment you would be using the monthly payment of your principal + interest + homeowners insurance + taxes. As an example, let’s say your rent is $800 and your income is $2,000. Your Front-end ratio would be:

$800/$3,000=0.2667 x 100 = 26.67%

Back-End Ratio

Debt-to-Income Ratios Unlimited Mortgage LendingFirst, add up all monthly payment debts that you presently have.  Your debts are such creditors that you would have for a mortgage or rent, auto loans or leases, child support, and credit card (min.) payments, student loan payments (deferred or not), child support, etc.  Generally, you would be able to see most of your creditors listed on your credit report.  You can get a copie Next, you calculate your gross monthly income which is the income amount before taxes and deductions. Now that you have your total monthly debt payment and your total gross monthly income, you now divide the Total Monthly Debt Payment by your Total Gross Monthly income.  With that answer you time it by 100 to give you a percent.

For example, assume you pay $800 for your rent, $300 for your car lease, and $200 for all other monthly debts. Your monthly debt payments would look like this:

  • $800 + $300 + $200 = $1,300

If your gross income for the month is $3,000, your debt-to-income ratio would be 43.33% ($1,300 / $3,000 = 0.4333 x 100).

Applying for a Mortgage and DTI Ratios

When you complete a mortgage application, you will have to provide documentation depending on the type of loan that you are applying for that will reflect your monthly debts and your monthly gross income.

When you complete your mortgage application and provide the required documentation, the lender will review your assets (money you have for a downpayment), your credit report and your monthly gross income. As previously illustrated, this information will be used by the lender to calculate how much of a home you can afford based on your debt to income ratios.

To get approved for a mortgage, the general guideline calls for the front-end and back-end ratios to be no more than 28% and 36% respectively expressed as 28/36. But being  in the mortgage industry for 20+ years, I have had borrowers approved  with ratios at 39/49.99.  The reason for the increase in the general ratios is due to many factors specific to that borrower such as the individual’s credit score, assets, downpayment, longevity at their job, etc.

There are no two borrowers that are the same and each has their own merits that come into play for an approval.  I would say not to be discouraged if your ratios are higher than the general guideline but if they are higher than 50%, you will have some work to do.  Using a mortgage loan originator/mortgage loan officer is the best advice that I can give you. Such as myself, we have the expertise of how to help you work towards an approval.

Credit Score and Your DTI

Your DTI ratio does not directly affect your credit score. The credit bureaus do not know what your gross monthly Debt-to-Income Ratios Unlimited Mortgage Lendingincome is, so it is impossible for them to calculate your dti ratios.

Your credit score is directly affected by your debt amount to your credit line limit utilization.  In simple words, this is the amount of money you owe against the credit limit (revolving lines of credit not fixed installment loans).  This is expressed as a percentage and is called the credit utilization ratio.  The higher the debt vs the credit limit the higher the utilization percentage is and that causes a decrease in your credit score.  The reverse is also true. The lower the debt balance is vs your credit limit the lower your utilization percentage is and this causes an increase in  your credit score.

For example, if you have credit card balances totaling $5,000 with a credit limit of $6,000, your debt-to-credit ratio would be 83.33% ($5,000 / $6,000 = 0.8333, or 83.33%).  Also, if you go over your credit limit, it is like getting a double whammy against you and a major decrease in your credit score. In general, the more a person owes relative to their credit limit—how close to maxing out the cards—the lower the credit score will be.

Lowering Debt-to-Income (DTI) Ratio

Basically, there are two ways to lower your debt-to-income ratio:

  • Reduce your monthly recurring debt
  • Increase your gross monthly income

Of course, you can also use a combination of the two. Let’s return to our example of the debt-to-income ratio at 43.33%, based on the total recurring monthly debt of $1,300 and a gross monthly income of $3,000. If the total recurring monthly debt were reduced to $300, the debt-to-income ratio would correspondingly decrease to 33.33% ($1,000 / $3,000 = 0.3333, or 33.33%).

Similarly, if debt stays the same as in the first example but we increase the income to $4,000, again the debt-to-income ratio drops ($1,300 / $4,000 = 0.325, or 32.5%).

Of course, reducing debt is easier said than done. It can be helpful to make a conscious effort to avoid going further into debt by considering needs versus wants when spending. Needs are things you have to have in order to survive: food, shelter, clothing, healthcare, and transportation. Wants, on the other hand, are things you would like to have, but that you don’t need to survive.

Once your needs have been met each month, you might have discretionary income available to spend on wants. You don’t have to spend it all, and it makes financial sense to stop spending so much money on things you don’t need. It is also helpful to create a budget that includes paying down the debt you already have.

To increase your income, you might be able to do the following:

  • Find a second job or work as a freelancer in your spare time.
  • Work more hours or overtime at your primary job.
  • Ask for a pay increase.
  • Complete coursework and/or licensing that will increase your skills and marketability, and obtain a new job with a higher salary.
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