What is debt-to-income ratio, and how does it affect your mortgage?
Learn how to calculate your debt-to-income ratio, an important factor in determining your final mortgage amount.
Quick insights
- Debt-to-income ratio (DTI) measures the amount of debt you have against your overall income.
- It’s one of the most important factors in your mortgage applications because it gives lenders a good idea of whether you’ll be able to make your monthly payments.
- Generally, a good debt-to-income ratio is lower than 36%, but that doesn’t mean a DTI higher than that will disqualify you from a home loan.
If you're a first-time homebuyer, the mortgage process may, at times, seem overwhelming. Even if you earn a steady income and pay your bills on time, other variables could affect your chances of getting a mortgage.
Debt-to-income ratio is one metric lenders will look at to assess your financial situation. Let’s take a closer look at how to calculate DTI and what a good ratio means for mortgage loan approval.
What is debt-to-income ratio (DTI)?
This figure represents the amount of debt you have against your income. DTI is a way for lenders to assess your financial health and creditworthiness.
If a large chunk of your income goes toward paying down debt, that means your DTI is high. In contrast, if a small percentage of your income is spent on debt, your DTI is low. Lenders typically want to see that your DTI is low, as it tells them you'll be able to manage your monthly payments with minimal issues.
Lenders also look at the history and trajectory of your debt-to-income ratio. Say, for example, you increased your income from $100,000 to $250,000 in one year. A home lender may not automatically underwrite a much larger loan—they’ll want to understand the why behind the jump. Was it a big salary increase? A one-time sale of a house or stocks? Will that $250,000 income continue?
How can I calculate my debt-to-income ratio?
The easiest way to calculate your debt-to-income ratio is to add up all your monthly debt payments and divide that amount by your gross monthly income. Let’s walk through the steps in more detail:
1. Add up your monthly debt payments
Begin by totaling your monthly debt payments. These should include payments for:
- Rent or mortgage
- Student loans
- Credit cards
- Car loans
- Personal loans
- Lines of credit
- Child support or alimony
Generally, expenses such as gas, utilities, insurance and groceries aren’t included in debt-to-income ratio calculations, as these are considered living expenses.
2. Divide the total by your income
Divide the debt number you just calculated by your total gross monthly income (income before taxes). Include all sources of income, including your salary from full-time work, any part-time wages or freelance income, bonuses, Social Security benefits or child support payments received.
The formula to calculate your DTI is as follows:
DTI = (Total of your monthly debt payments / your gross monthly income) x 100
The result is expressed as a percentage.
3. Review your final number
The number you generated in the previous step is your debt-to-income ratio. The lower the DTI percentage, the less risky you tend to be to lenders.
Most lenders rely on what’s called a “back-end” ratio when calculating DTI, which refers to the portion of your income needed to cover all of your monthly debt obligations (such as credit cards and student loans) plus your housing expenses.
However, there are some that calculate based on a front-end ratio, which only shows what percentage of your monthly gross income would go toward housing expenses.
DTI ratio example
If you pay $1,500 a month for your mortgage, $200 a month for an auto loan and $300 a month for remaining debts, your monthly debt payments add up to $2,000. If your gross monthly income is $6,000, then your debt-to-income ratio is 33% ($2,000 is 33% of $6,000).
On the other hand, if your gross monthly income is $6,000, and you are paying $3,000 in monthly debt, your debt-to-income ratio is 50%.
Why is debt-to-income ratio important in mortgage approval?
In addition to your income, lenders will review related housing expenses, such as condominium dues and homeowner’s association (HOA) assessments, insurance premiums, mortgage insurance and other recurring obligations.
While a high credit score is considered good, a low debt-to-income ratio is a more important factor. It helps lenders see the bigger picture of your finances, providing reassurance that you’ll be able to make your monthly payments. Put simply, this information helps lenders minimize the risks associated with approving your loan.
What is a good debt-to-income ratio?
Generally, a good debt-to-income ratio is lower than 36%, but that doesn’t mean a DTI higher than that will disqualify you from a home loan. If you have a higher DTI, your lender might ask you to meet other eligibility requirements. For example, you may need to make a higher down payment or get a cosigner.
However, some lenders may accept higher ratios depending on what kind of loan you’re applying for. Some conventional loans backed by Fannie Mae and Freddie Mac now accept a DTI as high as 50%Opens overlay if it goes through manual underwriting. Talk to your lender about what ratio you should aim for.
Remember, reducing your debt is a smart move because it can boost your credit score and lower your DTI ratio over time.
What is the 28/36 rule?
The 28/36 rule is a general approach used to calculate how much debt an individual should assume.
The rule is that a household should spend no more than 28% of its gross monthly income on total housing expenses (including mortgage debt, insurance and property taxes) and no more than 36% on debt in total.
Lenders use this formula to determine how much debt a consumer can sustainably take on without overextending themselves and potentially defaulting on loans. Using this rule to figure out what percentage of your income you should spend on your mortgage is smart, since it allows borrowers to have slightly higher DTI ratios as long as they have better credit scores.
How to improve your debt-to-income (DTI) ratio
If you’re concerned that your DTI may impact mortgage prequalification, there are various strategies that could help you lower your DTI over time. Because your DTI compares your monthly debt payments to your gross monthly income, you can potentially improve it by reducing what you owe, increasing your earnings or a combination of both.
- Create a focused debt payoff plan: Prioritize revolving balances, such as credit cards, which will help lower your monthly obligations more quickly.
- Explore lowering your interest rates: If a creditor approves a lower interest rate or offers a refinance option, the savings may be applied toward faster debt reduction.
- Be cautious about taking on new debt: Keeping balances from growing could help your DTI ratio trend in the right direction.
- Consider additional income sources: If your mortgage lender doesn’t count certain income from side work, you can still use that money to reduce debt.
- Apply unexpected funds wisely: Tax refunds, bonuses or other lump-sum earnings may help reduce balances and improve your DTI ratio.
Mortgage providers may also include student loan payments in your DTI calculation, depending on the loan type, status and payment schedule. Understanding how payments are reported to loan providers may help you plan more effectively.
In summary
Your debt-to-income ratio is a metric that compares your debt payments to your income. Lenders use this ratio to determine how you’ll be able to manage debt, plus additional loan payments.
While the ideal debt-to-income ratio is lower than 36%, you aren’t automatically disqualified from a home loan if yours is above that. Take steps to reduce your DTI and talk to your lender about your options. Keeping your DTI ratio under a certain amount can increase your mortgage approval chances and possibly your loan terms. In general, the less debt you have when buying a home, the better.
