When you apply for a mortgage, a lender considers your debt-to-income ratio as a critical measuring stick. You could have a good credit score, stable earnings and pay all your bills on time, but if monthly debt payments eat up too much of your income, a lender will take that into account when determining your ability to take on a mortgage.That’s why it’s just as important to know your debt-to-income ratio, or DTI, as it is to check your credit score before applying for a mortgage.
“People are so focused on their credit scores and on getting a low interest rate that they forget to look at the big picture of their financials,” explains Ed Conarchy, a mortgage planner and investment adviser at Cherry Creek Mortgage Co. in Gurnee, Illinois.
“Your debt-to-income ratio plays a huge role — it’s a number that can impact whether or not you’re getting a mortgage in the first place,” Conarchy says.
How to calculate debt-to-income ratio
First, there are two types of ratios lenders evaluate:
- The front-end ratio, also called the housing ratio, shows what percentage of your income would go toward housing expenses, including your monthly mortgage payment, property taxes, homeowners insurance and homeowners association fees, if applicable.
- The back-end ratio shows how much of your income would be needed to cover all monthly debt obligations. This includes the mortgage and other housing expenses, plus credit cards, auto loan, child support, student loans and other debts. Living expenses, such as utilities and groceries, are not included in this ratio.
The back-end ratio may be referred to as the debt-to-income ratio, but both ratios are usually factored in when a lender says they’re considering a borrower’s DTI.
To calculate your front-end ratio, add up your monthly housing expenses and divide it by your gross monthly income, then multiply the result by 100. For instance, if all your housing-related expenses total $1,800 and your gross monthly income is $6,000, your DTI is 30 percent.
To determine the back-end ratio, add up all your monthly debt payments, including your housing expenses, and divide the result by your monthly gross income.
Let’s say you have a car loan that is $500 per month, you pay $150 per month in student loans and $200 per month toward credit card bills. That adds up to $850.
Combine that with your $1,800 in monthly housing expenses and you get $2,650 in total monthly debts. Based on your monthly income of $6,000, your back-end ratio would be 44 percent.
Ideal debt-to-income ratio for a mortgage
Lenders generally look for the ideal front-end ratio to be no more than 28 percent, and the back-end ratio, including all monthly debts, to be no higher than 36 percent.
So, with $6,000 in gross monthly income, your maximum amount for monthly mortgage payments at 28 percent would be $1,680 ($6,000 x 0.28 = $1,680). Your maximum for all debt payments, at 36 percent, should come to no more than $2,160 per month ($6,000 x 0.36 = $2,160).
In reality, however, depending on your credit score, how much you have in savings and the size of your down payment, lenders may accept higher ratios. Limits vary depending on the lender and the type of loan.
For conventional loans, most lenders focus on your back-end ratio, according to Matt Hackett, mortgage operations manager at Equity Now in New York. Although not written in stone, most conventional loans require a DTI of no more than 45 percent, but some lenders will accept ratios as high as 50 percent if the borrower has compensating factors, such as a savings account with a balance equal to six months’ worth of housing expenses.
For FHA loans, the recommended front-end ratio is 31 percent and recommended back-end ratio is 43 percent — but as with conventional loans, there are exceptions that bump the cap higher.
How to get around a high DTI
The easiest way to lower your debt-to-income ratio is to pay off as much debt as you can — but many borrowers don’t have the money to do that when they’re in the process of getting a mortgage, because much of their savings are tied up in a down payment and closing costs.
If you think you can afford the mortgage you want but your DTI is above the limit, a co-signer might help solve your problem. Unlike with conventional loans, borrowers can have a relative co-sign an FHA loan and the co-signer won’t be required to live in the house with the borrower. The co-signer does need to show sufficient income and good credit, as with any other type of loan.
Sometimes, though, a co-signer isn’t the answer.
“Just because you are able to get approved doesn’t mean you should get approved,” Conarchy says. “If your DTI is too high, maybe it’s time to take a step back and get your finances together before you commit to a mortgage.”