If you’re thinking about buying a home, be prepared to run into an abundance of acronyms like FHA, LTV, ARM and PMI, just to name a few. But one of the most important of these terms is DTI, because your ability to borrow money depends on it.
DTI is short for “debt-to-income” ratio. It’s one of the tools lenders use to determine whether you qualify for a mortgage, how much money you can borrow, and what type of monthly payment you can afford. But not everyone understands what DTI is or how lenders use it.
How is DTI calculated?
Basically, your DTI ratio is the percentage of your gross monthly income that goes toward paying your monthly debts and other obligations. Your gross income is what you earn before taxes and other items are deducted. Your debts usually include rent, the minimum required credit card payments and car payments. It can also include student loan payments and child support payments, if you have them.
However, DTI doesn’t include everything you spend money on every month. For example, it doesn’t include utility bills, food, entertainment, or the money you put into savings or retirement.
When you apply for a loan, a lender calculates your DTI ratio by taking all your existing monthly obligations and substitutes your rent for what your monthly mortgage payment will be. For example, let’s suppose your expected mortgage payment will be $1,500, your existing credit card payments are $500, your car payment is $200. That would total $2,200 per month in proposed expenses. If your gross monthly income is $5,000, your DTI ratio will be 44%.
So, what DTI do I need to get a loan?
The best answer is that it depends. Obviously, the lower your DTI, the better. A low DTI is a sign that you handle your finances well and can afford to make your mortgage payment in cases where a financial hardship may occur. Historically, borrowers with higher DTI ratios are more likely to run into trouble paying their mortgage because they have very little left over each month to handle extra unanticipated expenses.
The maximum DTI allowed varies between different lenders and different loan programs. Generally speaking, a DTI ratio of 38% or less is considered good, as it shows a lender that you should be able to manage your debts comfortably. A DTI above 38% usually means your lender will look more closely at other factors to determine whether you qualify, such as your credit score and how much “reserves” you have. Reserves are what’s left over in your bank account after you pay for your down payment and closing costs. This means that having extra money in your bank accounts can also help your lender know that you can manage unanticipated expenses if they come up.
Most lenders won’t lend money to borrowers with a DTI higher than 45%, but there are programs that allow higher DTI levels if you meet certain requirements.
How can I lower my DTI?
There are two basic ways to bring your DTI ratio down, and they’re pretty obvious—either increase your gross monthly income or lower your monthly debts.
Using our example above, let’s say you pay off your car loan, thus eliminating that $200 monthly payment. Such a move would lower your DTI to 40%, which places you in a little better shape. If you have high-interest rate credit cards, you could also pay those balances down before you begin your mortgage application process—or transfer your card balances to a card with a lower interest rate to reduce your monthly debt payment.
You could also increase your gross monthly income by switching to a higher paying job. However, lenders like to see a history of consistent income from borrowers. For this reason, changing jobs too soon before applying for a mortgage or after you’ve applied is not a good idea. You might also consider getting a part-time job to supplement your income, but know that your lender may not be able to consider that extra income from your part time job without having a history of receiving it for 2 or more years
It should be pretty easy now to see why DTI is important. However, DTI is only one tool lenders use to decide whether to approve your loan. Your lender will take your entire financial picture into account, including your credit, your income, and savings.
If you have more questions about DTI or want to find out what kind of mortgage payment you can afford, just reach out to a Right by You Mortgage loan expert at inquiries@rightbyyoumortgage.com, or call us at 877-552-2242. Our team is Right By You every step of the way.
