A Homebuyer’s Guide to Debt-to-Income Ratio

Just when you've figured out how your credit score is calculated, lenders start talking about debt-to-income ratio, or DTI. Although it's a similarly important number, your credit score focuses on how punctually you pay your debts, whereas debt-to-income ratio looks at the amount of debt itself.

Anyone thinking of buying a home in the next few years needs a thorough understanding of DTI ratio. Here's what it is, how to calculate it, and most importantly, how to improve it.

Debt-to-income ratio — often abbreviated to DTI — is one of the most important financial indicators to a lender considering making you a loan.

The DTI ratio is calculated as a percentage, comparing your regular monthly debts to your regular monthly income. Your DTI ratio is a reflection of your financial situation since it shows lenders how you are managing current debt and how much income you have to spend at the end of an average month after paying your bills.

Understanding Income for DTI Ratio

Before you start calculating your debt-to-income ratio, you'll want to fully understand what goes into each of the numbers involved — with the first being the income portion of the ratio. This means yours and yours alone (unless more than one person will be on the loan).

Income for purposes of DTI ratio means gross monthly salary — or the amount you earn before taxes are taken out. If you are self-employed, it means self-employment income. Any other recurring income source can also be included, like alimony, child support, Social Security benefits of any type, rental income from real estate you own, pension income, and even lottery-winning annuity income (should you be so lucky!). A lender won't include one-time payments or short-term payments, like one-time gambling winnings. Rather, lenders focus on income you expect to receive for the term of a mortgage. Temporary, sporadic, unreliable, or unpredictable income is usually excluded.

Calculating monthly debt also has specific rules. There are two types of DTI ratios: one called front-end/housing ratio and the other called back-end ratio. Front-end just looks at your monthly house payments if you currently own a house or your monthly rent. It also includes any real estate taxes or homeowners'/condo dues you pay.

The back-end ratio includes all of the housing expenses and also other debts like family support payments (spousal or child support payments), student loan payments, vehicle loan payments, credit card minimum payments, and retail account payments. You'll also need to add in all collection account payments or payments due for overdrafted accounts or delinquent tax repayment plans.

What about other payments that aren't actually debts but are based on contracts? Bills like insurance — health, vehicle, or life insurance — are not added into debts and neither are cell phone bills, your heating or electric bills, storage unit rent, or streaming television or music subscriptions.

The actual calculation for DTI ratio is fairly easy once you know your total relevant monthly debt payment amount and total monthly income. The formula basically divides the former by the latter. Be sure you understand whether you are calculating front-end ratio (housing debt only) or back-end ratio (housing plus all other debts).

For example, if your total monthly debts are $2,500 and your total monthly income is $5,000, your debt-to-income ratio is 2,500/5,000, or 0.5. To get the percentage, multiply this by 100. The result of 0.5 x 100 is 50 percent. If this were your circumstance, your DTI ratio would be 50 percent.

In general, the lower a debt-to-income ratio, the better for anyone hoping to get a mortgage loan. That is, 10 percent is better than 20, which is better than 30, which is better than 40, etc. Lenders will have their own ideal DTI ratio for borrowers and often their own maximum as well, so it pays to check. Typically, mortgage lenders like to see a back-end debt-to-income ratio that is between 28 and 36 percent, and anyone with a DTI ratio in this range is considered a low-risk borrower.

Most lenders have a maximum DTI ratio. For example, the Federal Reserve sets a maximum back-end DTI ratio for credit at 40 percent, but often, lenders use 43 percent as the maximum. While federal programs, like the Federal Housing Administration, indicate a cap of 43 to 50 percent DTI, they do insure loans for borrowers with DTI ratios above 50 percent.

Practical Significance of DTI Ranges

If you already know your back-end DTI range, you may be wondering what it means in terms of your own finances and how you are dealing with debt. Consider this general breakdown of what different DTI ranges mean for you:

• DTI ratio under 36 percent: You have your debts well under control vis-a-vis your salary. Most lenders will be happy to see you walk in the door. You are doing well dealing with your finances.
  
• DTI ratio between 36 and 42 percent: You have more debt or less income in this scenario, and you may be getting overextended. Make paying down some debts a priority.
  
• DTI ratio between 43 and 50 percent: Your debt level is high, and you may want to wait to buy a home until you reduce the amount you owe. Consider a consult with a credit-counseling agency.
  
• DTI ratio over 50 percent: You are unlikely to get a mortgage without either increasing your monthly income or decreasing your monthly debt. Reducing your debt level may be difficult, and you should consider all options.
  

Since housing costs alone are represented in a front-end DTI ratio, it is no surprise that an ideal front-end DTI ratio will be lower than an ideal back-end DTI ratio. Not all lenders set the same maximum front-end DTI ratio, but the general rule of thumb is that housing costs should not exceed 28 percent of gross monthly income. Anything over 30 percent is considered high.

What would this look like? Let's assume you have a gross monthly income of $6,000. The front-end DTI ratio would be 28 percent of $6,000, or $1,680. So, if you had a rent payment of $1,000, you would be well under the 28 percent maximum. However, a rent payment of $2,000 would be well over the maximum. With gross monthly income of $8,000, you could pay up to $2,240 in rent or home mortgage and taxes to be considered in an ideal front-end DTI ratio.

Lenders are likely to be more interested in your projected front-end debt-to-income ratio than your current front-end DTI ratio. This type of front-end DTI ratio factors in the housing costs you will have if the mortgage loan is granted, and you buy a home in the price range you are considering. It will include real estate taxes on that home as well as any homeowners' association or condo association fees.

Like with current front-end DTI ratio, lenders want to see a projected front-end DTI ratio of 30 percent or under. This time, the calculation will include your projected monthly mortgage payment rather than your current rental payment. In fact, projected front-end DTI ratio is a factor in determining how much of a mortgage loan you can afford. For example, if your gross monthly income is $6,000, you will not be able to afford a mortgage with monthly payments that are over $1,680 a month (28 percent of $6,000).

It's easy to mix up credit score factors and the debt-to-income ratio. It's natural to wonder how the two are connected since these two calculations are perhaps the most critical to borrowing money or extending credit.

However, your credit score is not impacted by your DTI ratio. Prepared by credit reporting bureaus, your credit score is based on how well you keep up with your current debt payments. For example, if you have monthly debt payments that eat up 75 percent of your gross monthly salary, you can still have a good credit score if you always pay your bills on time. On the other hand, your DTI ratio will be way too high to get a loan.

One factor in your credit score is your credit-utilization ratio. This compares the total amount of credit you're using compared to your credit limits on credit cards. To maintain a good credit score, you should keep your balances to less than a third of your credit limit. This may lower your monthly credit card payments, which will be good overall for your DTI ratio. However, if your monthly rent or payments for car loans or student loans are high, you might still have too high of a DTI ratio.

Since your debt-to-income ratio compares your monthly debts to your monthly income, the only way to improve it is to change one of those factors. That is, you can raise your income or lower your debts. Each one will make your DTI ratio more attractive to lenders.

For example, if you currently gross $5,000 a month and pay $2,000 a month in rent, $300 a month toward credit cards, $200 a month toward student loans and $300 a month for a car payment, you have a front-end DTI ratio of 2,000/5,000, or 40 percent, and a back-end DTI ratio of 2,800/5,000, or 56 percent. Both of these are too high to snag a typical mortgage loan. However, if you raise your income to $7,000 a month, your front-end DTI ratio drops to an acceptable 29 percent, and the back-end DTI ratio drops to a workable 40 percent. (Of course, raising your income $2,000 a month is no small feat.)

Alternatively, if you move to a new place with $1,000 a month rent and pay off the credit cards, you have a front-end DTI ratio of 20 percent (1,000/5,000) and a back-end DTI ratio of 30 percent (1,500/5,000). These numbers will also be acceptable to a lender.