Debt to Income Ratio | How to Not Get Stuck When Getting A Loan
Your credit score plays a big and important role in your financial life. However, there is another equally important number that you can never take for granted–your debt to income (DTI) ratio.
When I was getting my a loan for my personal residence, I ran into problems with my debt to income ratio. In fact, the bank was not going to give us the loan because our debt to income ratio was only 5% lower than needed. (You'll learn more about that later in the article)
What is the Debt to Income Ratio?
The debt to income ratio is calculated as all your monthly debt payments divided by your entire monthly gross income. Banks use this ratio to determine if you qualify for the loan you are asking for.
Monthly Debt payments / Monthly Gross income = DTI Ratio
The debt to income ratio is a calculation that shows banks how viable you are as a borrower. Too much debt and too little income will indicate to the banks that you are a high risk borrower and may default on the loan they give you.
Remember that this is only calculating debt, not your expenses. Expenses can be cut but debts cannot.
Here is a quick list of the types of debts that would be included in the debt to income ratio:
- Credit card debt
- Student loans
- Car loans
- Lines of credit
- Payday loans
Someone with a DTI of 60% has a higher likelihood of missing a payment than someone who has a DTI of 20%.
Debt to Income Ratio Example:
An example would be someone who makes $4,000 a month in gross income and who has $2,200 in monthly debt payments.
BAD DTI: $2,200 / $4,000 = 55% DTI
This would be a very high DTI and banks would most likely not lend to him/her.
An example of a good DTI would be where the income is $4,000 a month and the debt payments are total of $1,200 a month.
GOOD DTI: $1,200 / $4,000 = 30% DTI
Lenders use this information to identify how well you manage your debts and whether or not you can afford to repay a loan.
Ways to Lower Debt to Income Ratio to Be Qualify for a Loan
Before we get into too much more about the debt to income ratio, I want to give you ways to make your Debt to Income ratio lower. If you use these ways to lower debt to income ratio, banks will want to lend to you.
- Increase your income
- Pay more toward your debt each month
- Don't take on more debt
- Don't make large purchases with the credit you have
- Pay down the accounts where the debt is close to the credit limit
Increase Your Income
- Drive for Uber or Lyft
- Start a passive income business like a podcast
- Start a blog like this one and make money with affiliates
- Drive for Door Dash
- Drive for Uber Eats
- Write a book and earn royalties
Every way that you can increase your income will help you with your debt to income ratio to get your next loan.
Pay More Toward Your Debt Each Month
By lowering the amount of debt you actually have, you will automatically have a lower debt to income ratio.
This can be as little as $10- $50 extra a month toward your debt. Every little bit helps.
I personally had to cut out many expenses like:
- eating out
- going to movies
- skip the special coffee
- no more energy drinks
- take cold showers (Seriously… Cuts on the water heater bill)
All of these things will put more money in your pocket that you can then use to pay down your debt.
Lowering that debt to income ratio is the key here and cutting your expenses will go a long way to doing that.
Don't Take on More Debt
Obviously, if you increase the amount of debt you have, the higher your debt to income ratio will be.
So don't take on more debt. 🙂
Don't Make Any Large Purchases
Even if you have the money to make a large purchase, you need to think hard if that large purchase is worth it.
The money that goes to the large purchase could be put to your debt instead of the next item.
Think about what is more important. The loan you are trying to get or the large purchase.
Pay down the accounts where the debt is close to the credit limit
Think of how banks look at your debt. If you have a credit of $5,000 but you are using $4,700 of it, it looks like you are using all your debt.
Bad: $5,000 total credit | $4,970 borrowed
Better: $5,000 total credit | $2,000 borrowed
A tip would be to lower the amount of debt on the credit accounts that are the closest to the total credit amount.
Why does the Debt to Income Ratio Matter?
Plain and simple, borrowing money from a bank is a risk that banks take and they want to make sure they lend money to the borrowers who will repay the loan with interest.
If you apply for a loan from a bank to purchase a home, there are many checks the bank will do to qualify you as a qualified borrower.
- Credit score
- Outstanding debts
- Previous years tax returns
- W2 statement from your current job
- Proof of employment with paycheck stubs
From this information, the bank will put together a profile of you as a borrower. Among all the information, the debt-to-income ratio is very important for the banks.
If you have too much debt compared to your income, the bank will believe that you will not have the ability to repay the loan they are giving you.
What is a Good Debt to Income Ratio?
Having less debt, in the eyes of the bank, is very beneficial.
Having a lower DTI ratio helps the bank to see that you are a borrower who can pay back their loan.
If you are considering getting a loan in the future, work to lower your DTI Ratio. Lowering your loan payments or increasing your income will make you a more attractive borrower.
Each bank has its own criteria for the DTI of their borrowers but the range general range is between 36% and 43%.
If you have more than 43%, it will be very hard to get a loan.
DTI Rule of Thumb for Getting a Loan
A good rule of thumb for your debt to income when getting a loan is the 28/36 rule.
According to this general rule of thumb, a household must not spend over 28% of gross income every month on housing (also known as front-end DTI) while the total ratio, also known as back-end DTI, should be at a maximum of 36%.
I'll explain more about the front-end and back-end ratio in a bit.
How Do You Calculate the Debt to Income Ratio?
To find your DTI, you simply divide your total payments by your gross income.
For Example: If you have $2,000 a month in debt payments and you earn $6,000 per month your DTI would be 33%. (2,000/6,000 = .33)
Here are the four steps in calculating your DTI ratio:
- Add up everything you owe, such as your rent, mortgage, or credit card payments, student loans, car loans, and everything else expected for you to pay constantly every month.
- Calculate your income including your dividends, wages, alimony, freelance income, and others.
- Convert each of these incomes into a monthly figure.
For example, if you have an annual income of $60,000, your monthly total will be $5,000. The same thing can be done for your debt. If you have an annual debt of $30,000, your monthly total will be $2,000.
- Divide the debt you have by your income then multiply this by 100. The percentage you will arrive will represent your DTI or debt to income ratio. In the example above, this will be 30,000 divided by 60,000 equals .5 times 100 equals 50%.
What Counts as Debt Payments
You will want to include all your debt payments such as:
- Minimum credit card payments
- Payday loans
- Investment loans
- Car loans
- Consumer loans
- Personal notes
- Car payments monthly
- Student loans
You will also want to include any other “required” monthly expenses, even if they aren’t debt. Such as:
- Property taxes
- Mortgage payments
- Homeowners insurance
- HOA expenses
- Court-ordered child support payments
- Court-ordered alimony payments
What counts as income?
- Your salary
- Your spouse's salary
- Any income from freelancing, a side hustle, or part-time job
- Court-ordered child support you receive
- Court-ordered alimony you receive Alimony and child support
- Social security
- Bonuses and tips
- Any extra income
Dividing your monthly debt payments by your gross monthly income will give you a decimal. Multiply that decimal by 100 to turn it into a percentage.
What is the Debt-to-Income Ratio to Qualify for a Mortgage?
At present, the maximum debt to income ratio a homebuyer is allowed to have in order to apply for a qualified mortgage is 43%. But it is recommended that your DTI be less than 36%.
Qualified mortgages, for example, don’t have any excessive fees. They also help borrowers stay away from loan products such as negative amortization of loans that can make them more prone to financial distress.
Financial institutions like banks prefer to lend cash to homebuyers who have lower DTI ratios. A DTI ratio that is higher than 43% will imply that the buyer might actually be a precarious borrower.
Obviously, it is better to have a lower DTI ratio. Borrowers who have lower debt to income ratios have higher chances of being qualified for lower mortgage rates.
How Fees Affect Your DTI Ratio
When you speak of the front-end ratio, this considers debt’s direct relationship to the mortgage payment. This is being calculated by adding the homeowner’s insurance, mortgage payment, real estate taxes, and applicable homeowner’s association fees.
The sum is divided by the monthly income.
For instance, if the mortgage payment, taxes, fees, and insurance equals to $2000 monthly and your monthly income is $6000, your front-end ratio is 30% as you will divide 2000 by 6000.
Lenders would want to see 28% or less front-end ratio for conventional loans and 31% or less for the FHA loans.
How Banks Use the Debt-to-Income Ratio When Approving Loans
The way banks use the DTI ratio for giving out a loan is simple. If your debt to income ratio is too high, then you will not get a loan.
There is good news if your debt-to-income is too high though. Each and every bank will have their own specific DTI threshold before they give a loan to a borrower. So shop around if one bank turns you down.
Banks are concerned about two things:
- Not losing the money they already have
- Making more money with the money they already have
In finding which borrower they will lend to, banks have criteria that they go by to figure out who is a worthy borrower. This is a part of vetting the potential borrower to see if they will be able to repay the loan.
What is the Debt to Income Ratio to Buy a House?
This all depends on if you are buying a home for yourself or a rental property as an investment.
If you are buying a personal residence, banks see this as being a necessity for you and your family. They will give a little more latitude to you as the borrower to buy a home to live in.
If the property is an investment, all that matters are the numbers. Banks will look at all your debts and income to make sure that, even if you do not have the property rented, you will still make your mortgage payment.
The lenders calculate the debt-to-income ratio by dividing your obligations monthly by your gross, income or pretax. The majority of the lenders look for a 36% ratio or less even if there are exceptions.
2 Kinds of Debt-to-Income Ratio
Lenders usually divide the details that make up debt to income ratio into two different categories known as back-end ratio and front-end ratio before they make the final decision whether they will provide a mortgage loan or not.
There are 2 kinds of DTI and these include the following:
- Back-end Ratio
It includes every other debt you pay each month including credit cards, car loans, personal loans, and student loans aside from the proposed household expenses. A back-end ratio tends to be higher since it takes into account all your debt obligations monthly.
- Front-end Ratio
It is also referred to as household ratio. It’s the dollar amount of any home-related expenses such as your property tax, proposed mortgager every month, homeowners association fees, and insurance, divided by your gross income per month.
Which of the Types of Debt-to-Income Matters?
Typically, while mortgage lenders look at the kinds of debt-to-income, your back-end ratio frequently holds more sway for the reason that it takes into account the whole debt load.
Many lenders tend to concentrate on the back-end ratio for the conventional mortgages, loans offered by banks or online mortgage lenders instead of government programs.
If the front-end debt-to-income ratio is below 28 percent, then it’s good. If the back-end debt-to-income ratio is below 36 percent, that is much better.
When you are applying for a non-conventional mortgage like FHA loan, the lenders would look at the ratios and would consider debt-to-income ratios that are much higher than the ones needed for a conventional mortgage.
This can be up to 31 percent for front-end and 43 percent for back-end. There are times that lenders would even allow ratios to go higher slightly.
Ideally, most of you would want debt-to-income ratios are low if possible, no matter what the limits of the lenders.
Lower debt-to-income ratio would boost your credit score that might enable you to get low mortgage interest rate.
Maximum Debt to Income Ratio for Mortgage
In order for you to achieve a qualified mortgage, which is a consumer-friendly kind of loan, the total ration you should have should be below 43%. This rule has some exceptions.
Federal regulations require the lenders to show that you have the ability in repaying any home loan they approve and your ability’s key part is debt-to-income ratio.
You are the ultimate judge of what you could afford. You do not need to borrow the maximum to you and it is frequently better to borrow less.
If you borrow the maximum, it may put a strain on the budget and it is much difficult to absorb surprises including schedule change, job loss or any unexpected expense.
Keeping debt payments to a minimum makes it much easier to put the money towards some goals like retirement or education costs.
How You Should Use Your Debt-to-Income to Your Benefit
Remember that any kind of debt, such as credit card balances, student loans, personal loans, mortgages, or auto loans, will be able to increase your DTI ratio, together with costs such as alimony or child support payments.
These all can be a factor for banks when calculating your debt-to-income ratio.
On the other hand, your income from a job together with other freelance or part-time work as well as the alimony payments you get are all part of your gross income. This total gross income is what the bank will use for the DTI ratio.
If you are considering getting a loan in the future, working to lower your DTI Ratio now will help you in the future.
By lowering your loan payment total dollar amount and increasing your income, you will be more attractive as a borrower to every bank.
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