Why Your Debt-to-Income Ratio Matters
Your debt-to-income (DTI) ratio and credit history are two important financial health factors lenders consider when determining if they will lend you money. Your DTI ratio compares how much you owe with how much you earn in a given month.
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A debt-to-income ratio is derived by dividing your monthly debt payments by your monthly gross income (income before taxes). The ratio is expressed as a percentage, and lenders use it to determine how well you manage monthly debts, and if you can afford to repay a loan.
Generally, lenders view consumers with higher DTI ratios as riskier borrowers, because they might run into trouble repaying their loan in case of financial hardship.
To calculate your debt-to-income ratio, add up all of your monthly debts – rent or mortgage payments, student loans, personal loans, auto loans, credit card payments, child support, alimony, etc. – and divide the sum by your gross monthly income.
For example, if your monthly debt equals $3,000 and your gross monthly income is $9,000, your DTI ratio is about 33% ($3,000/$9,000 = 0.333).
Let’s Get Specific.
There are two components mortgage lenders use for a DTI ratio: a front-end ratio and back-end ratio.
Front-End Ratio (AKA “the housing ratio”): Shows what percentage of your monthly gross income would go toward your housing expenses (monthly mortgage payment, property taxes, homeowners insurance and homeowners association dues, etc.).
Back-End Ratio: Shows what portion of your income is needed to cover all of your monthly debt obligations, plus your mortgage payments and housing expenses (credit card bills, car loans, child support, student loans and any other revolving debt that shows on your credit report).
Keep in mind that other monthly bills and financial obligations - utilities, groceries, insurance premiums, healthcare expenses, daycare, etc. - are not part of this calculation. Your lender isn't going to factor these budget items into their decision on how much money to lend you. AKA - just because you qualify for a $500,000 mortgage, that doesn't mean you can actually afford the monthly payment that comes with it, when considering your entire budget.
Lenders typically say the ideal front-end ratio should be no more than 28 percent, and the back-end ratio, including all expenses, should be 36 percent or lower.
How Can I Lower My Debt-to-Income Ratio?
Make a Budget: Track your spending by creating a budget, and reduce unnecessary purchases to put more money toward paying down your debt. Make sure to include all of your expenses, no matter how big or small, so you can allocate extra dollars toward paying down your debt.
Examine Interest Rates: Make your debt more affordable. If you have high-interest credit cards, look at ways to lower your rates. Consider consolidating your credit card debt by transferring high-interest balances to an existing or new card that has a lower rate. Taking out a personal loan is another way you could consolidate high-interest debt into a loan with a lower interest rate and one monthly payment to the same company.
Avoid Taking On More Debt: Don't make large purchases on your credit cards or take on new loans for major purchases. This is especially important before and during a home purchase. Not only will taking on new loans drive up your DTI ratio, it can hurt your credit score. Likewise, too many credit inquiries also can lower your score.
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