What is a debt-to-income ratio?
A debt-to-income, or DTI, ratio is derived by dividing your monthly debt payments by your monthly gross income. The ratio is expressed as a percentage, and lenders use it to determine how well you manage monthly debts -- and if you can afford to repay a loan.
Generally, lenders view consumers with higher DTI ratios as riskier borrowers because they might run into trouble repaying their loan in case of financial hardship.
What factors make up a DTI ratio?
There are two components mortgage lenders use for a DTI ratio: a front-end ratio and back-end ratio. Here's a closer look at each and how they are calculated:
- Front-end ratio, also called the housing ratio, shows what percentage of your monthly gross income would go toward your housing expenses, including your monthly mortgage payment, property taxes, homeowners insurance and homeowners association dues.
- Back-end ratio shows what portion of your income is needed to cover all of your monthly debt obligations, plus your mortgage payments and housing expenses. This includes credit card bills, car loans, child support, student loans and any other revolving debt that shows on your credit report.
How is the debt-to-income ratio calculated?
Here's a simple two-step formula for calculating your DTI ratio.
- Add up all of your monthly debts. These payments may include:
- Monthly mortgage or rent payment
- Minimum credit card payments
- Auto, student or personal loan payments
- Monthly alimony or child support payments
- Any other debt payments that show on your credit report
- Divide the sum of your monthly debts by your monthly gross income (your take-home pay before taxes and other monthly deductions).
- Convert the figure into a percentage and that is your DTI ratio.
Keep in mind that other monthly bills and financial obligations -- utilities, groceries, insurance premiums, healthcare expenses, daycare, etc. -- are not part of this calculation. Your lender isn't going to factor these budget items into their decision on how much money to lend you. Keep in mind that just because you qualify for a $300,000 mortgage, that doesn't mean you can actually afford the monthly payment that comes with it when considering your entire budget.
What is an ideal debt-to-income ratio?
Lenders typically say the ideal front-end ratio should be no more than 28 percent, and the back-end ratio, including all expenses, should be 36 percent or lower. In reality, depending on your credit score, savings, assets and down payment, lenders may accept higher ratios, depending on the type of loan you're applying for.
For conventional loans backed by Fannie Mae and Freddie Mac, lenders now accept a DTI ratio as high as 50 percent. That means half of your monthly income is going toward housing expenses and recurring monthly debt obligations.
Does my debt-to-income ratio impact my credit?
Credit bureaus don't look at your income when they score your credit so your DTI ratio has little bearing on your actual score. But borrowers with a high DTI ratio may have a high credit utilization ratio -- and that accounts for 30 percent of your credit score.
Credit utilization ratio is the outstanding balance on your credit accounts in relation to your maximum credit limit. If you have a credit card with a $2,000 limit and a balance of $1,000, your credit utilization ratio is 50 percent. Ideally, you want to keep that your credit utilization ratio below 30 percent when applying for a mortgage.
Lowering your credit utilization ratio will not only help boost your credit score, but lower your DTI ratio because you're paying down more debt.
How to lower your debt-to-income ratio
To get your DTI ratio under better control, focus on paying down debt with these four tips.
- Track your spending by creating a budget, and reduce unnecessary purchases to put more money toward paying down your debt. Make sure to include all of your expenses, no matter how big or small, so you can allocate extra dollars toward paying down your debt.
- Map out a plan to pay down your debts. Two popular ways for tackling debt include the snowball or avalanche methods. The snowball method involves paying down your small credit balance first while making minimum payments on others. Once the smallest balance is paid off, you move to the next smallest and so forth.
On the other hand, the avalanche method, also called the ladder method, involves tackling accounts based on higher interest rates. Once you pay down a balance that has a higher-interest rate, you move on the next account with the second-highest rate and so on. No matter what way you choose, the key is to stick to your plan. Bankrate.com's debt payoff calculator can help.
- Make your debt more affordable. If you have high-interest credit cards, look at ways to lower your rates. To start, call your credit card company to see if it can lower your interest rate. You might have more success going this route if your account is in good standing and you regularly pay your bills on time. In some cases, you may realize it's better to consolidate your credit card debt by transferring high-interest balances to an existing or new card that has a lower rate. Taking out a personal loan is another way you could consolidate high-interest debt into a loan with a lower interest rate and one monthly payment to the same company.
- Avoid taking on more debt. Don't make large purchases on your credit cards or take on new loans for major purchases. This is especially important before and during a home purchase. Not only will taking on new loans drive up your DTI ratio, it can hurt your credit score. Likewise, too many credit inquiries also can lower your score. Stay laser- focused on paying down debt without adding to the problem.