Debt-to-income (DTI) ratio is a personal finance metric that represents the percentage of a person’s monthly income that is spent on debt payments. Most lenders like to see a DTI of between 36 and 43 percent.
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You likely know that having good credit will improve your chances of being approved for a loan. However, credit score alone is certainly not the only factor lenders review when making loan decisions. The larger the loan amount, the more the lender will scrutinize the applicant, which is why applying for a mortgage can be such an intense and time-consuming adventure.
Imagine an applicant has an exceptional credit score and is trying to purchase a $650,000 home. That kind of credit score is certainly going to look appealing to a lender. But what if the applicant works a minimum wage job? The mortgage lender may decline the applicant because a minimum wage income is simply not enough to cover monthly payments on a $650,000 home. Having an income high enough to comfortably afford a debt payment can be measured by calculating a person’s debt-to-income (DTI) ratio.
The DTI ratio is a very important factor when a lender is deciding whether to approve someone for a large loan, especially a mortgage. Every lender has its own DTI requirements; however, according to the CFPB, the general rule of thumb is that a person’s total debt payments should stay below 36 to 43 percent of that person’s monthly income.
How is your debt-to-income ratio calculated?
A lender will calculate a person’s debt-to-income ratio to decide whether that person has enough room in their budget to cover the new loan payment. Your DTI is calculated by totaling all your monthly debt payments, including:
- Mortgage loans (or rent)
- Auto loans
- Student loans
- Personal loans
- Minimum credit card payments
- Alimony, child support and other financial judgments
Next, the lender will calculate your gross monthly income. This is how much you make per year, before taxes and other deductions, divided by 12 months. The final DTI is found by taking the total of all debt payments and dividing it by the gross monthly income. Here’s an example calculation:
- A person’s monthly debt payments total $2,150. This includes $1,000 mortgage + $600 auto + $200 student loan + $350 credit cards.
- The person has a salary of $90,000 which, divided by 12 months, equals $7,500 gross income per month.
- Total debt of $2,150 divided by a monthly gross income of $7,500 equals a DTI of 29 percent.
Front-end vs. back-end DTI
Every lender is free to develop (within the confines of federal civil rights laws) its own lending standards and calculations to decide whether a person is a qualified loan applicant. Lenders can pick and choose which types of expenses to include in their DTI calculation. The two most common calculations for DTI are called front-end and back-end.
A front-end DTI calculation includes only housing-related expenses such as the mortgage payment plus the monthly home insurance payment. So it represents just the percent of monthly income used for housing expenses.
A back-end DTI calculation includes all monthly debt payments (mortgage, auto, credit card, etc.), like in the example above. This is the most commonly used DTI calculation as it provides the most holistic picture of a person’s debt situation.
How will lenders look at your debt-to-income ratio?
Each lender has its own requirements for potential loan applicants, so there’s no way to confidently say what DTI number is needed to get a loan. Also, your debt-to-income ratio is just one factor that’ll be taken into consideration, along with your credit score, credit history, down payment size, presence of cosigners, cost of living in the area, type of mortgage and others factors.
In general, the lower your DTI, the better. Lenders love to see you have plenty of room in your monthly budget to absorb the new loan payment while still having money left over for monthly living expenses and emergencies.
Common DTI ranges are as follows:
- A back-end DTI below 36 percent likely means you have a healthy and manageable debt load.
- Lenders will often tolerate a DTI between 36 and 43 percent, as these are the most common DTI ranges in America.
- Under the right circumstances, some lenders may consider a DTI of 44 to 49 percent.
- If you have a back-end DTI of 50 percent or more, the chances of being approved for a loan are very slim. A DTI that high sets off alarm bells that you’re dangerously close to being unable to pay all your bills.
Does DTI affect credit score?
No, your DTI doesn’t impact your credit score. The credit reporting companies don’t keep a record of your income, so there’s no way for them to incorporate income into the scores they produce.
However, your credit score is heavily impacted by a similar but different calculation called the credit utilization ratio. This measurement is calculated by totaling all revolving credit balances (the amount you’ve actually spent using your credit cards) and dividing it by your credit limits (the maximum amount lenders will let you spend using the cards).
Let’s say you have a credit card with a $3,000 balance and a $10,000 maximum. Divide the balance by the maximum and you have a credit utilization ratio of 30 percent on that card. Individuals suffering financial hardship often max out their cards, causing their credit utilization ratios to be very high. This is something you want to avoid, if possible.
How to lower your DTI
Having a healthy DTI (generally below 36 percent) is important if you want to qualify for a loan, especially a mortgage. A healthy DTI also means you have a monthly budget that’s better prepared to cover living expenses and emergencies. In theory, lowering your DTI is a fairly straightforward concept: you need to increase your income, or lower your debt (or both).
Increase your income
This option for improving your DTI is perhaps easier said than done. Increasing your income requires you to get a raise, get a new job or get a second job. If you find a way to increase your income, make sure it’s sustainable over the long term—are you really going to be able to work 70 hours a week for the next 30 years to afford that mortgage?
Reduce your debt
Paying down your existing debt is the healthiest option for improving your DTI. Not only will your chances of being approved for a loan increase, but you’ll also enjoy having extra spending money in your monthly budget.
Identify the bad debt in your life and make a concerted effort to pay more than your minimum payment each month. Perhaps you can temporarily take on a second job and use the extra money to pay off existing loans. Another excellent option is to reduce the interest rates on your existing loans by consolidating your debt.
Understanding and improving your debt-to-income ratio can be a complex and confusing task. Lexington Law is here to help you by providing a variety of articles related to many financial topics. We also offer leading credit repair services. Sign up today to get a free credit report consultation that’ll include your credit score, credit history and credit repair recommendations.
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