First-time homebuyers run into plenty of new terms during the homebuying process. One of these terms is debt-to-income ratio (DTI), and it’s considered a key indicator of financial health. Lenders use your debt-to-income ratio to determine if you can repay a loan. They also use it to decide how much money to loan you.
While lenders may differ in their requirements for DTI, it’s a standard metric used throughout the mortgage industry. This makes it vital to understand what DTI is, how it is calculated and why it’s considered an important indicator of your financial wellbeing.
What Is Debt-To-Income Ratio?
Your debt-to-income ratio (DTI) is how much debt you have compared to your income. This quickly shows a lender how much money you have coming in that isn’t already owed on other debts.
Lenders see lower DTIs as an indication that you are more capable of making payments if they give you a loan. Higher DTIs are seen as a potential red flag, indicating that you may already have too much debt and could be at risk of being unable to repay the loan.
Although your DTI is a standard way to measure your ability to repay a loan, there are some variations on calculating it. Different lenders also have different standards on what is an acceptable DTI ratio.
Front-end DTI
Front-end debt-to-income ratio looks at how much of your income is used for housing-related expenses. This can include costs related to your primary home, including the principal, interest, insurance and even property taxes. Because it only uses housing costs, it is sometimes called your housing or housing expense ratio.
Back-end DTI
Back-end DTI ratio looks at all of your debt in comparison to your income. This calculation will include housing expenses and uses auto debt, credit cards, student loans and other types of debt. Your back-end DTI is higher than your front-end DTI simply because it includes all monthly debt payments, not just housing.
It’s not uncommon for lenders to calculate both your front-end dti and back-end DTI during the qualification process.
How to Calculate Debt-To-Income Ratio
Your DTI is usually shown as a percentage, and it’s calculated by dividing your monthly debt payments by your monthly gross income. So while the types of debts included in the DTI may change, the calculation itself is the same.
Let’s take a closer look at where these numbers come from and how the calculation is handled.
Add up your minimum monthly payments
To calculate your DTI, you need to have an accurate list of monthly payments. For front-end DTI, only housing-related costs are used, such as mortgage payments, property taxes and insurance.
Your back-end DTI includes the following types of monthly debt payments:
- Rent or mortgage payment
- Monthly child support or alimony
- Monthly auto payments
- Monthly loan payments, including student and personal loans
- Monthly credit card payments
When adding your credit card payment, you can use the minimum required even if you usually pay more. You typically do not include money spent on utilities, gas for your car, groceries or similar expenses.
Divide monthly payments against gross monthly income
DTI is a ratio of money coming in compared to money going out, so once you have gathered all of your eligible expenses and added up your gross monthly income, you have to do a little math. Let’s look at an example to see how DTI works.
If your gross monthly income is $5,000, and the following are your monthly debts:
- $1,500 rent
- $300 car payment
- $75 credit card payment
Your total debt equates to $1,875.
You would divide $1,875 by $5,000 to get 0.375. A lender would compare this against their DTI requirements to determine if you qualify for a loan. They would also use it to decide how much money you qualify for, which you would use as a guide as you search for homes.
Convert to a percent
DTIs are expressed in percentages. So after you’ve divided your monthly payments by your gross monthly income, you have to convert the answer from a decimal into a percentage. Let’s look at this final step using the information in the example above.
You divided $1,875 by $5,000 to get 0.375. To convert this decimal into a percentage, you can multiply it by 100 or move the decimal point two places to the right. In this example, you would move the decimal from 0.375 over two places, making the DTI 37.5%.
What Is a Good Debt-To-Income Ratio for Mortgage?
DTIs provide a quick snapshot of your available money once you’ve paid your debts. A lower DTI suggests that you have more available money, while a higher DTI suggests that you have less available money. While a DTI of 36% or less is often considered good, lenders use different DTI requirements to decide someone's credit worthiness.
Conventional loans
Depending on the lender’s requirements, a conventional mortgage may have a DTI limit of up to 46%. Occasionally, a lender may allow a DTI nearing 49% if compensating circumstances exist. For example, someone with very strong credit but a higher DTI may still qualify.
FHA loans
The Federal Housing Administration (FHA) is not a lender but insures loans for qualified homebuyers. This gives lenders a safety net and allows them to loosen their mortgage requirements so more people can qualify. Typically, the FHA sets a maximum DTI of up to 43%.
USDA loans
The US Department of Agriculture (USDA) has a loan program to help people in rural areas address housing needs. The standard DTI for a USDA home loan is up to 41%. However, they extend this up to 46% with compensating factors. This may include a strong credit score, significant down payment or other variables.
VA loans
The Department of Veterans Affairs, or VA, has a program to help veterans become homeowners. There are several requirements to qualify, including spending a certain amount of time in active service. Additionally, they have a maximum DTI of 41%.
Secure Mortgage Financing Through The Money Store
Your debt-to-income ratio is a quick and easy tool to assess your financial situation. With this single number, a lender knows how much of your money is free and how much is dedicated to monthly payments. And while it’s easy to see why DTIs are a foundational number for mortgage lenders, having your home ownership dream tied to a single number is a bit intimidating. This makes understanding the homebuying process and working with a reputable mortgage lender vital in making the leap from renter to homeowner.
Not sure where to start? We encourage you to contact The Money Store with your mortgage-related questions.