If you are about to apply for a mortgage, the chances are that you have spent the past months building up your credit score. But your FICO score is not the only indicator that matters – and it is certainly not the only factor lenders consider when drafting your mortgage terms. That’s why it is time to focus on your Debt-to-Income (DTI) ratio.
This percentage is all but a negligible one, and it can significantly impact how much you’ll be able to borrow, which houses you can afford, and what interest rates will apply on your loan. Here’s all you need to know before submitting your application.
What Is the Debt-to-Income Ratio?
The debt-to-income ratio (DTI) is a measure of how much of your monthly gross income is used to repay your existing debt. For example, a 20% DTI ratio shows that, each month, 20% of your gross income goes towards repaying outstanding balances like credit card debt, auto loans, and student loans.
Generally, a low DTI ratio is an indicator that your household receives sufficient income to comfortably afford debt servicing, while a high percentage might show that you have taken out too much debt for your income and, therefore, makes you a riskier borrower.
In the US, the average DTI changes from state to state, but it has been steadily growing over the past 20 years. That is why you should calculate your ratio today and make sure you are within a good range.
To calculate your DTI ratio, you will need:
- Your gross monthly income – or your income after taxes
- The total amount of your debt – which includes your mortgage payments, auto loans, and credit card balances.
You will then need to divide your total debt by your gross income. For example, if your total debt is $1,200 a month and your gross monthly income is $5,780 (figures reflecting the national average), your DTI ratio would be 0.207, or 20.7%.
The Importance of a Good DTI: Why Lenders Look At This Factor
All established lenders, including online personal finance services like SoFi, will assess several factors to get a snapshot of your financial health. These include your FICO score, employment history, Loan-to-Value ratio, and the DTI ratio.
In particular, lenders use your DTI ratio to get an understanding of how you are managing your earnings and debt, and whether you’ll be able to comfortably afford your monthly mortgage repayments.
After all, you might be earning above average but dealing with overwhelming debt. Or vice versa, your income might be just above the minimum wage but your personal finances might be in perfect order.
What’s more, the DTI ratio determines both your borrowing risk AND your mortgage terms. As seen above, your DTI ratio will tell a lending institution how risky it is to lend you money.
In turn, if you are a high-risk subject, the lender might still decide to offer you a mortgage, but you’ll have to deal with reduced borrowing limits, higher APR and interest rates, and larger monthly repayments – which can affect your finances for the next 2-to-3 decades!
What Is a Good DTI? Learn About the 28\36 Rule
Generally, borrowers are required to have a maximum DTI ratio of 43% to be eligible for a mortgage. However, the great majority of lenders will only reserve the best mortgage terms for applicants with a total DTI ratio below 36%.
But bear in mind that this 36% should account for the total amount of your debt – including your mortgage monthly payments. More specifically, lenders tend to focus on the 28\36 rule.
This rule specifies that:
Your front-end ratio – or the percentage of your gross monthly income that goes towards mortgage repayments – should not be greater than 28%
Your back-end ratio – or the percentage of your gross monthly income that goes towards your total debt servicing – should not be greater than 36%
Aside from mortgage payments, your back-end ratio will also include child support, alimony, car loans, student loans, and credit card payments.
Tips To Lower Your DTI Before Applying for a Mortgage
Lowering your DTI ratio can take months. That is why it is important to look at this percentage as soon as you decide to take out a mortgage.
Some tips to lower your DTI include:
- Increase your monthly income through a promotion, passive income, or side hustle
- Reduce your overall debt by making larger repayments – or repaying more than the minimum each month
- Reduce your unnecessary expenses
- Refinance or consolidate your loans to reduce interests
- Focus on repaying high-interest loans
- Extend the life of your existing loans to reduce monthly payments
- Avoid taking out more credit and postpone any large expenses you had planned
- Keep an eye on your DTI ratio and check on your progress
Since the lower your DTi ratio is, the higher chances you’ll have to get approved for a mortgage, you should always consider the tips above – even if you have a good current debt-to-income ratio hovering around 36%.
Work With a Financial Advisor
The DTI ratio is only one of the factors a mortgage lender will look at when deciding on the terms of your home loan. However, it is not an indicator that should be overlooked.
If you are getting closer to submitting your mortgage application, make sure to speak to an experienced financial advisor to learn how to boost your overall financial health.