Home Buying 101 Series
Why, oh why, would someone as fun-loving as you want to read a boring article about debt-to-income ratio? There’s absolutely nothing exhilarating about it (sorry CPAs and loan officers). But, if you’re considering the purchase of a home, your debt-to-income ratio (DTI) is a “must know.” The good news is that your debt-to-income ratio is super easy to calculate on your own.
First Things First
What is a debt-to-income ratio? It’s your amount of debt compared to your income. If you earn $50,000 a year and have $12,000 a year in debt payments (think student loans, credit cards, car loans etc), then you have a 25% DTI, which is great!
Why Do I Need to Know My Debt-To-Income-Ratio?
Before a lender loans you tens of thousands of dollars toward a home purchase, they want to know how likely you are to pay the mortgage back to them. Studies have shown that borrowers with a low amount of debt compared to their income are more likely to make their monthly payments and those with high debt-to-income ratios often struggle. Everyone wants you to succeed and not struggle.
What is a good Debt-to-Income Ratio?
Most lenders prefer a debt-to-income ratio around 35-36% or less. However, anywhere from 0% (no debt) up to 43% is considered good enough to borrow and still get a Qualified Mortgage according to the Consumer Financial Protection Bureau. Why such a range? Because the debt-to-income ratio isn’t the only thing being considered when applying for a loan, and each lender has their own guidelines.
How to Calculate your Debt-to-Income Ratio
To calculate your debt-to-income ratio, first add up all your monthly debt payments. Then, divide them by your gross monthly income. Your gross monthly income is the amount of money you earn before your taxes and other deductions are taken out. For example:
18% DTI ratio is good! In the above example, the borrowers current rent payment is not considered as debt, however the lender will add an estimated monthly mortgage payment to determine a mortgage payment which you can afford and keep your total DTI at an acceptable level.
Here’s another example. If you pay $1500 a month for your mortgage, another $100 a month for an auto loan, and $400 a month for the rest of your debts, your monthly debt payments are $2,000. ($1500 + $100 + $400 = $2,000.) If your gross monthly income is $6,000, then your debt-to-income ratio is 33 percent. ($2,000 is 33% of $6,000.)
There’s More Work to be Done
How about it? Is your DTI below the magic 36%? Congratulations! You are likely to qualify for a home mortgage. A quick visit to a lender will help you determine your affordable price range in homes.
Is your Debt-to-Income Ratio between 36-43%? Don’t panic, as there are still lenders willing to work with you. Meeting with a lender will give them the whole picture of your finances and help them determine the best loan package for you. For example, did you just finish your education in a high income field such as brain surgery? Trust me, the lenders want to chat with you despite your higher debt-to-income ratio.
Is your Debt-to-income ratio above 43%? There’s still no need to panic. While you may not qualify for a home loan today, you can do some work on lowering your debt or increasing your income. It takes time, but you can do it!
Baby Steps to Improving your Debt-to-Income Ratio
There is an abundance of information available to help you with financial management. Most programs will start by creating a household budget. After that basic piece, the advice starts to vary quite a bit. Some programs are good, some are truly out to take your money with quick-fix plans so be careful not to get suckered.
The program I’ve heard the most about and seen people succeed with is the Dave Ramsey Financial Peace University. Their debt repayment program is simple: pay off the smallest debt first then use the amount you used to pay for the smallest debt and apply it to the next smallest debt. As you pay off debts, you get an emotional boost from knowing you are making progress AND you begin to make bigger and bigger payments toward the larger debts.
You Can Do It!
You’ve got this. If you manage your budget and get creative, I’m confident you can save money for a down payment, get your debt-to-income ratio into the proper range, and soon qualify for a home loan. As always, feel free to contact us with any questions you may have. If we can't answer them ourselves then we will point you in the right direction.
Written by Lois Marris | Edited Madison Bissonette