The amount of debt you owe determines your ability to pay back, live within a comfortable budget, and even fulfill other financial goals. In American society where loans are the norm, the amount you owe will further influence your ability to secure new loans.
The Debt-to-income (DTI) ratio is a metric that’s used to estimate the amount you owe relative to your income. It enables lenders to determine if you can take on new loans. In this post, we’re going to explore what it’s all about and why it’s important.
What is Debt-to-income Ratio?
The debt-to-income ratio is all your monthly payments divided by your gross monthly income. It is usually expressed as a percentage. Your gross income is your total pay before taxes and other deductions are removed.
Let’s examine a concrete example to make things clearer.
Assume you have a bunch of different debts:
- A $500 per month student loan payment.
- A $50 per month credit card payment.
- A $300 per month car payment.
- A $1,000 per month mortgage payment.
- And $500 per month for other miscellaneous debt payments.
You total monthly debt payment works out to be $2,350 (500 + 50 + 300 + 500 +1000). Let’s assume your annual salary before tax is $90,000. Your gross monthly income will be $60,000 divided by 12, which gives $7,500.
Debt-to-income ratio = Total Monthly Payments / Gross monthly income.
In this case, that’ll be 2,350 divided by 7,500. This works out to be 0.3133 or 31.33%.
Front-end and Back-end DTI ratios.
Debt-to-income ratios are one of the major factors considered when applying for a mortgage. Mortgage lenders, in turn, calculate two types of DTI ratios: front-end and back-end ratios. That’s why it’s important we note the distinction.
- Front-end Ratio
This measures ONLY the amount that will be spent on housing, including the principal, interest, property taxes, and insurance compared to your income. So, if the new mortgage loan will require you to make monthly payments of $1,500 and your monthly gross income is $7,500, your front-end ratio will be $1,500 divided by $7,500, which works out to be .2 or 20%.
- Back-end Ratio
For the back-end ratio, it includes ALL the monthly payments you will be required to make, including mortgage, auto loans, credit card, and more. So, extending the last example, let’s say all your monthly payments before taking on the mortgage loan is $1,200. Therefore, your total monthly payment after you secure the mortgage will be $2,700 ($1,200 + $1,500). Your back-end ratio will then be $2,700 divided by $7,500, which is .36 or 36%.
What is the Ideal DTI Ratio?
Generally speaking, the lower your DTI ratio, the better. However, many other factors determine your ability to secure a loan. Some of these include the type of loan you’re looking for, as well as your credit score and credit history.
- A DTI ratio of less than 36% is considered to be good because your debt is manageable when compared to your income.
- A DTI ratio between 36% and 49% is considered okay, though there’s still room for improvement. However, some lenders might be wary because any unforeseen expense like a medical emergency can quickly make your debt unmanageable.
- A DTI ratio greater than 50% is considered poor. It means you’re using more than half of your monthly income to settle your debts. In general, securing a loan with this DTI ratio will be extremely difficult and unfavorable.
What’s a Good DTI for a Mortgage Loan?
Mortgage lenders typically want, at most, a 28% front-end ratio and a 36% back-end ratio. If it’s higher than that, most lenders will deny your application because you’re considered high risk.
However, a DTI ratio of 43% is the highest a borrower can have and still get a Qualified Mortgage. Larger lenders may be able to give you a mortgage loan if your DTI ratio exceeds 43%, even if it prevents you from being a Qualified Mortgage. But they’ll have to make a good-faith effort and abide by CFPB’s regulations to determine that you’ll be able to repay.
As a general rule of thumb, if you have a high DTI ratio, do not seek out a mortgage loan. It will take you further in debt. This means you’ll have a hard time living within your budget and saving might be impossible. Furthermore, if you consistently default on your payments, you may lose your home. So, why add to your financial burden if you cannot afford it?
How to Improve Your DTI Ratio
Mortgage lenders aren’t the only ones that make use of DTI ratios. Your DTI ratio will be used as a factor when seeking an auto or personal loan. If you have a high DTI ratio, reducing it below 36% will be helpful. There are two primary ways to improve your DTI:
Reduce Your Debt
Any action you take to reduce the amount of debt you have will reduce the number of monthly payments you have to make. This, in turn, will reduce your DTI. Here are some things you can do:
- Increase your monthly payment to quickly clear off some of your debt. This will increase your DTI temporarily but once you’re done, your DTI will drastically reduce.
- Do not take in additional debt. Your credit card wisely. Do not use it to make large purchases, at least, in the meantime to avoid racking up more debt.
- If your auto payment is too high, you can consider getting a cheaper car.
Increase Your Income
Any action you take to earn more income will also reduce your DTI ratio, all other things being constant. Here are some of the things to consider.
- Ask for a raise from your employer (if you deserve it).
- Walk multiple jobs so you can earn more.
- Get more education or certification so you can earn more.
Monitor Your Progress
As you take action to reduce your DTI, monitoring your DTI ratio monthly will give you the motivation you need to stay on track.
Before you get too fixated on your DTI ratio, remember that it’s only one of the several aspects of your financial profile lenders take into consideration before approving a new loan. The type of loan you’re interested in, the size of your down payment, your credit history, and your work history are also important factors. However, having a good DTI ratio will surely add to your attractiveness as a borrower.
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