How to Lower Your Debt-to-Income Ratio

After assembling the paperwork that your mortgage lender needs and performing a few cursory calculations based on your total monthly debt payments and your total assets, you may find that your debt-to-income ratio is a little too high. This all-important benchmark can push your mortgage approval forward or hold it back for a little tweaking — with the goal of bringing it within your mortgage lender's underwriting guidelines.

Some mortgage lenders do not rely solely on an acceptable debt-to-income ratio, also called DTI or DTI ratio, for mortgage approval, but a high DTI is typically a deal-breaker for mortgage approval from most lenders. Although some lenders may approve a mortgage when a borrower has a DTI of 43 percent, ideally, a DTI should be less than 36 percent.

The light at the end of the mortgage-approval tunnel is that there are actionable ways you can lower your DTI and move forward with the lending process. You may have simply overlooked some assets that could lower your DTI to an acceptable threshold, or you may be able to tackle some credit card debt and successfully improve your financial health to receive the green light for homeownership.

Lenders shoulder a measure of liability when funding mortgage loans. Because mortgage amounts are significantly higher than consumer loans for things like bedroom furniture or an entertainment center, potential homeowners must meet more rigorous qualifying guidelines. Because there's so much at stake for mortgage lenders when borrowers default, lenders must consider the ability of each borrower to make timely mortgage payments.

In addition to other monthly payments, payments for credit cards, car loans and student loans take a chunk out of monthly income and potentially affect a borrower's ability to make each mortgage payment. So, it's not enough for a borrower to qualify for a mortgage solely on the basis of having a high income. Income must be reduced by the borrower's total monthly debt to make sure there's enough "month left at the end of the money," which offers lenders a measure of confidence in a borrower's ability to make mortgage payments. Calculating the debt-to-income ratio is one tool that helps lenders assess the strength of a borrower's financial health.

To calculate your debt-to-income ratio, divide your total monthly debt payments by your gross monthly income (the amount before taxes are taken out of your pay) and then multiply the result by 100 to determine the percentage. Don't include certain expenditures, such as utility payments, or other monthly costs, such as groceries. Do include debts, such as loan installments, credit card repayments and rent or mortgage payments. For example, if you pay $400 each month on credit card debt, $200 on your auto loan and $1,400 on rent or mortgage, your total monthly debt is $2,000. If your gross monthly income is $5,000, your DTI is 40 percent ($2,000 debt divided by $5,000 income x 100).

Although it may seem too simple, the two main ways to lower your DTI are increasing your monthly income or reducing your monthly debt. So, unless you're slated for a job promotion with a pay increase or you take on a second job to provide additional income, reducing your total monthly debt payments may be a more attainable goal.

But what kind of debt should you tackle to most effectively lower your debt-to-income ratio? For most homebuyers, it should be credit card debt. You may not be able to pay off your auto loan or student loan debt as quickly as you can pay off some credit card debt — mainly because their payoff amounts may be higher than your credit cards. Another bonus of paying off credit card debt before other types of debt is that they represent revolving debt, which impacts your credit utilization ratio (or the amount of credit you're using divided by the amount you have available) and therefore your credit score. Auto and student loans, which are installment loans, do not impact your credit utilization ratio.

Although your DTI ratio does not affect your credit score, debt in general can impact it, which is another piece of your borrower profile that the lender will examine. In other words, debt can make a major mark on how a lender evaluates you.

With the goal of lowering your debt-to-income ratio to at least 36 percent, start by avoiding additional credit card debt. Next, begin paying down your existing balances by choosing the strategy that works best for you. Two common strategies are the "debt snowball" and the "debt avalanche" methods.

To use the "debt avalanche" method, you'll pay off the credit card with the highest interest rate first, then the card with the next-highest rate and so on. Because interest charges tack on a significant amount to overall card balances, paying off the card with the highest interest rate first will allow you to channel the money you would have spent on paying these interest fees (as well as the principal amount) toward the balance on your card with the next-highest interest rate. Make the minimum required payments on all your lower-interest-rate cards as you make additional monthly payments — as much as possible — toward the balance on the card with the highest interest rate.

To use the "debt snowball" method, you'll pay off the credit card that has the lowest balance first regardless of the interest rate and then pay off the card with the next-lowest balance and so on. Make the minimum required payments on all your other cards as you make the highest possible payment on the card with the lowest balance. When you've paid off this card, channel the money you've been paying on this one toward the card that now has the lowest balance. Although using the debt avalanche method will save money on interest charges in the long run, the debt snowball method allows borrowers to realize small accomplishments earlier in the card-payoff goal, which can help motivate many debt-weary consumers.

When you first implement a strategy to lower your debt-to-income ratio, it can be frustrating when you don't see immediate results, but if you stick to your plan and steadily continue to pay down debt, you'll be able to bring your DTI into an acceptable threshold for mortgage approval. Even though a DTI percentage is not listed on your credit report (because income is not reported), paying off debt impacts your credit score and in turn improves your DTI.

The three national credit bureaus — Equifax, Experian and TransUnion — adjust credit reports as soon as they receive updates from creditors. Creditors have different schedules and time frames for when they submit these updates. Typically, it's once every 30 to 45 days, but this is just an average. The time frame for when a borrower's DTI improves also depends on the amount of and frequency of debt repayment.

Technically, DTI immediately improves when you pay down debt, but lenders do not rely on their borrowers to confirm or furnish this information. Although some lenders may accept a letter from a borrower's creditor to vouch for debt reduction, a lender's underwriter (or underwriting department) must confirm this against the borrower's credit report. The credit report does more than confirm debt reduction; it also shows whether a borrower may have incurred additional debt from another creditor(s) as soon as older debts were retired or reduced.

If your credit score was marginal when you first applied for a mortgage and your debt-to-income ratio was also close to your lender's underwriting guidelines, you may have made several payments toward reducing your debt and improving your credit and DTI. If you think your financial health is now robust enough to pass muster with your lender, you can ask the lender to request a "rapid rescore" from the credit bureaus. In as short as a few days, you'll have an updated credit report that reflects recent debt repayment, and you may be on your way to a successful mortgage closing and homeownership.

However, if you still have a ways to go meet that benchmark of 36 percent, it may be wise to wait a while before shopping for a home until you can pay it down or increase your income.