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How to Calculate Debt-To-Income Ratio

By Veronica Nguyen · Nov 13, 2014 · Mortgage

How to Calculate Debt-To-Income Ratio

Image courtesy of Flickr, Horia Varlan

Your debt-to-income (DTI) ratio is used by mortgage lenders to determine how much of a monthly payment you can afford.

Similar to your credit score, your debt-to-income (DTI) ratio will determine if you qualify for a mortgage, and for how much. Your DTI is the percentage of your monthly income that you pay towards all your debts. The higher the number the riskier you are to a lender.

All your debts ÷ monthly income = DTI %

In other words, if you want to be able to qualify for a home loan, your DTI needs to be as low as possible. Take the steps necessary to calculate your DTI and make adjustments if needed.

Figure Out Your DTI

There are two DTI numbers lenders look at. Click here for a handy DTI Calculator, or look below and we'll show you how to calculate them and how they are used to approve you for a mortgage loan. If you're not happy with your DTI check out the tips provided below to help improve it.

The Front-End Ratio: What you pay towards mortgage payment

Only your housing debts ÷ monthly income = Front-End Ratio

The front-end ratio formula is what you pay towards housing divided by your gross income. What you pay towards housing is your proposed principal, interest, taxes, and insurance, also known as PITI. The ideal front-end ratio is 28%. Let's look at some examples below.

Example 1 - determine your front-end ratio

Monthly mortgage you can afford: $1,000
Your total monthly gross income: $4,000
Divide monthly mortgage by gross income: $1,000 ÷ $4,000 =
Your front-end ratio: 25%

25% is a great ratio that would be acceptable by mortgage lenders.

Now, let's look at it from another perspective. Let's say you want to know how much your maximum housing payment should be based on your gross income.

Example 2 - determine your maximum housing payment

Your total monthly gross income: $5,000
Target front-end ratio: 28%
Multiply gross income by front-end ratio: $5,000
x      .28
Your maximum housing payment: $1,400

As you can see there are two ways to use your front-end ratio. Staying below the lender's ceiling will increase your chances of getting approved for a mortgage.

The Back-End Ratio: Your total monthly debt commitments

All your debts ÷ monthly income = DTI %

Commonly referenced simply as as DTI, the back-end ratio is what you pay towards all your debt commitments divided by your gross income. Your total monthly debt commitment is made up of: your front-end ratio AND other recurring debt payments such as car, credit card, student loan, alimony/child support and other debt payments.

Your debt commitment does not include monthly expenses such as groceries, utilities, telephone and auto insurance.

Example 1 - determine your back-end ratio

Let's say Nancy wants to buy a house where the proposed mortgage payment is $2,200. Nancy also has monthly student loan payments of $100, a car loan payment of $250 and credit card payments of $100 a month. Nancy makes $90,000 per year which is $7,500 of gross income per month.

Add up all your debt:
     a) Proposed mortgage
     b) Student loan
     c) Car loan
     d) Credit card

+    100
+    250
+    100
Divide debt by monthly income: $2,650 ÷ $7,500 =
Your back-end ratio: 35.33%

A DTI of 35.33% is below the most common ceiling set by lenders of 36%. However, bear in mind that the lower your DTI the better loan terms you'll receive.

If you are above the DTI limits, all is not lost. There may be other loan options available to you at a higher cost, or you can make a large one-time payment and either reduce or payoff one of your debts to lower your DTI.

What Do Debt-To-Income Ratios Mean When Getting a Mortgage Loan?

It depends on the lender but the national DTI average is 36%. However, due to the new regulations some banks will go as high as 43% percent for a qualified mortgage. According to Fannie Mae, if your DTI exceeds 45% then you must also have the reserves and the credit score to be eligible for a loan.

Example DTI Ratios According to the Type of Loan

Conforming/Conventional Loans

These are loans that conform to Fannie Mae and Freddie Mac guidelines. Fannie and Freddie both use the back-end and front-end ratios. They currently allow up to 36% for the back-end ratio and 28% for the front-end ratio.

Non-Conforming Loans

These are loans that do not conform to Fannie Mae and Freddie Mac guidelines. Non-conforming loans typically utilize the back-end ratio to qualify and approve you for a mortgage. Jumbo loans (those loans above $417,000 for most of America) are one of the most common types of non-conforming loans and have been known to go as high as 55% DTI.

FHA and VA loans

These types of loans allow a back-end ratio up to 41%. Some lenders will even go as high 50% but this is going to depend on how strong your credit profile is. This includes your down payment, assets and credit score. Each situation can be very unique and the lender will ultimately make their decision based on your overall loan package and risk.

How Can You Improve Your DTI?

If you find that your debt-to-income ratio is higher than allowed by mortgage lenders, there's a lot you can do to improve it. The idea is to either increase your income and/or decrease your debt. Here are some ideas to help you:

  • Become a Landlord - Companies such as Airbnb helps you rent your room out like a hotel. The numbers vary, but regular Airbnb hosts claim to increase their income by as much as $10k to $30k each year! Alternatively, you could get a long-term roommate.
  • Rent Your Car - Why let your car just sit around when you're not using it? Rent it and make extra income! Check out sites like RelayRides and Getaround who claim owners can make up to $10,000 per year per car!
  • Become a Chef - Eat at home. If you eat out for breakfast, lunch and dinner, you'll spend more than $9,000 annually! If you only eat out for lunch you'll still spend more than $2,400. Eat before leaving the house, pack a lunch and cook a meal for dinner.
  • Pay More Towards Debt - Pay more than your minimum to pay off the principal balance quicker. For example, if you owe $1,000 on your credit card at 20% annually and make a minimum payment of $20 it'll take more than 8 years to pay off your debt!

By now you should see that your debt commitments and income are critical when it comes to getting approved for a mortgage. Check out the Debt-To-income Calculator to easily calculate your DTI.

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