Understanding DTI: Debt-to-Income Ratio

If you’re in the market to buy a home, chances are you’ve already been asked about your credit score and your current financial situation. While a hard pull of your credit is inevitable when purchasing a home and shopping around for a mortgage, the scrutiny doesn’t end there. Credit scores may be the most well known and frequently requested component of eligibility criteria, but lenders also require insight on another statistic -- one that isn’t as popular as a credit score but is every bit as important in determining borrower eligibility.

Beyond the Credit Score

Understanding a borrower’s creditworthiness is important and all, but it is still only a piece of the puzzle when it comes to determining the risk of loaning money to a potential borrower. Just as important, if not more important, is figuring out a borrower’s debt-to-income ratio or “DTI”. Your debt-to-income ratio, just as it sounds, is a value that expresses the relationship between your monthly debt obligations and your monthly income.

When it comes to figuring out if a borrower can afford to repay a loan, the debt-to-income ratio is an invaluable calculation. While a credit score is more of an intangible rating of a borrower’s creditworthiness, a debt-to-income calculation is a factual representation of how much a borrower owes each month in debt versus how much money they make.

What Is a Debt-to-Income Ratio?

DTI, or debt-to-income ratio, is a measurement expressed as a percentage that banks and lending institutions use to compare an individual’s monthly debt obligations to their gross monthly income. This calculation is very important because it’s a reliable way for lenders to determine a potential borrower’s predicted ability to repay future debts. In other words, DTI is used to measure just how much of your monthly income goes into repaying debt.

Unlike a credit score which is only a representation of how well a borrower has made payments on past and current debt obligations, a DTI is able to give the lender a better idea of whether or not a borrower will be able to repay a loan in the future.

The reason, of course, is because a borrower’s debt-to-income ratio takes into account all current debts as well as the borrower’s income in order to paint a clear picture of what a borrower can afford. This statistic, in recent years, has become much more important to lenders than a simple credit score when trying to determine the risk of entering into a mortgage agreement with a borrower.

When it comes to determining eligibility for a home loan, lenders often look at two different debt-to-income ratio values. The first value is the front-end DTI, which is a calculation that shows how much of the borrower’s monthly income will be put towards repaying the homeowners costs of principal, interest, taxes, and insurance (PITI).

The next value, and arguably the most important, is the back-end DTI. The back-end debt-to-income ratio takes into account ALL of a borrower’s expenses, including PITI on housing debt, and how much of the borrower’s monthly income is needed to afford to repay it all.

Calculating Front-End Debt-to-Income Ratio

For such an important value, calculating debt-to-income ratios is actually pretty simple. DTI is determined using a super easy formula, and the only variations involve which debts are being calculated. We know that the front-end DTI only represents the housing debt in relation to a borrower’s income, so it is the easiest figure to calculate out of the two.

To calculate the front-end debt-to-income ratio, the formula is the sum of the monthly housing expenses (PITI) divided by the by the borrower’s gross monthly income. The resulting value is then converted to a percentage, which is the borrower’s front-end debt-to-income ratio.

An Example of Front-End DTI

For example, let’s say you estimate that your monthly cost of principal, interest, taxes, and insurance for your new home will be around $1,447. Your gross monthly income (your income before taxes and other expenses are deducted), is $4000. Therefore the calculation becomes:

1,447 / 4000 = 0.36

When converted into a percentage, the result is a front-end debt-to-income ratio of 36%.

Calculating Back-End Debt-to-Income Ratio

Using the same method as above, you can easily calculate back-end DTI by dividing your total monthly debt (recurring expenses only), by your gross monthly income. In order to get a deeper understanding of the relationship between your gross monthly income and your debt, you will need to identify and add up all of your monthly debt expenses.

An Example of Back-End DTI

In addition to your housing debt of $1,447, let's say you have a credit card payments of $120, monthly student loan debt totaling $400, and a car payment of $300, when added up, you’d have a total monthly debt of $2,267.

Remembering that your monthly income is $4,000 a month, the calculation would be:

$2,267 / $4,000 = 0.57

Once converted into a percentage, that would give you a debt-to-income ratio of 57%.

Mortgage lenders love borrowers with lower DTIs since studies show that these borrowers are more likely to pay their debts on time and without any hassles. And why wouldn’t they be? It doesn’t take a rocket scientist to know that if you have more money available, it’s a lot easier to pay your bills.

What expenses count as debts when calculating your Back-End DTI?

When looking to calculate back-end DTI, pretty much any kind of monthly loan or debt counts toward the calculation, including auto loans, personal loans, credit card debt (which is calculated as the minimum monthly payment), garnishments and other court-ordered payments, like alimony, child support, and any student debt you may have.

Depending on the individual lender, your current rent or lease payment will not usually count toward your DTI (since you likely won’t be paying it once you have your new home), but it might. For this reason, it’s a good idea to ask a prospective lender exactly how they’re calculating your DTI.

Other living expenses, like food, non-recurring medical costs, cable, internet, gas, and electricity are not counted as part of DTI, because most of the time, they are not fixed charges, or they are nonessential recurring charges that can be canceled.

What DTI Do I Need to Get Approved for a Mortgage?

When mortgage lenders are looking to determine a borrower’s eligibility for receiving a home loan, they have an ideal DTI figure that a borrower must not pass. In most cases, you’ll need to have a back-end DTI of 43% or less to get approved for a mortgage. Despite that, having a DTI of less than 36% is best, and may be able to get you a much lower interest rate.

In terms of what lenders look for on the front-end, it is safe to assume that anywhere between 28% to 31% is the sweet spot. Of course, the FHA program requires a much more flexible range of 31% to 35%, depending on the financial fortitude of the borrower.

In general, lenders are looking for borrowers with low debt-to-income ratios, since it shows they are more capable of successfully taking on more debt. Remember, a lender’s main concern is whether or not a borrower will be able to repay the loan amount without defaulting. A lower DTI shows that they have much more monthly income than they have monthly debt obligations, which means they have more room to include the cost of a home loan than a borrower with a high DTI.

Borrowers with high debt-to-income ratios are regarded as high risk. Since they have debt obligations that seemingly take up a large portion of their monthly income, it is not likely that they will be able to afford to take on another, much larger debt such as a home loan.

That isn’t to say that borrowers with debt-to-income ratios higher than 43% can’t qualify for a mortgage. To be fair, different lenders have different requirements, as do the plethora of mortgage options on the market today. Fannie Mae, for example, accepts borrowers with DTIs up to 50%, although they are not eligible for a “qualified mortgage”, but more of a specialized home loan package with less protections.

You can also be sure that in cases where higher debt-to-income ratios are accepted, the other requirements are made more strict in an effort to reduce the risk for the lender.

How can I improve my DTI to get a better loan?

Having a high debt-to-income ratio is not a death sentence. It’s not like a super low credit score (which in this country can feel like a death sentence), that is enough to keep you from making even the simplest of financial moves. There are ways to combat an unfavorable DTI, and unlike with credit, the changes take effect much faster.

First and foremost, a well thought-out budget is the key to maintaining a good DTI. Budgeting seems more and more underrated as time goes by, but the importance of having a solid financial strategy has definitely only increased. Still, budgeting is only a part of the solution.

There are really only two main ways to improve and lower your DTI: reducing your monthly debt expenditure or increasing your income. Both affect one of the two factors of calculating your debt-to-income ratio.

Getting rid of debt can be hard to do, especially since they can be large amounts that are too far out of the range of affordability, but they can be reduced with a little extra cash each month.

Reducing Your Debt

For example, if you have credit card debt, you could reduce your debt expenditure by paying more than the minimum amount due each month or paying off your card balance if it isn’t too high. In other cases, you could try to pay off your auto loan, or refinance your vehicle into a loan with a lower monthly payment (though this might not be the right choice for everyone).

The other method of increasing your monthly income might be easier said than done, but well worth the effort. It might not be possible to get a raise with your current position, but If you can find a method of supplementing your current income, like with a second job for example, then it increases your monthly income, leaving more room to be able to comfortably afford more debt.

If neither course of action seems like it will work out in your favor, you can always try taking out a smaller loan, or perhaps making a larger down payment on the property you seek to purchase. Remember, your debt-to-income ratio should be just as important to you as it is to any lender. After all, it represents just how much you are responsible for paying each month in debts, without even factoring essential expenses like food and gas.

Debt-to-Income Ratio: In Review