When you are ready to apply for a mortgage loan, your lender will ask you for all sorts of financial information. One of the things lenders do with this data is to calculate your debt-to-income (DTI) ratio. A DTI ratio is one of the most basic methods lenders use to determine how much of a monthly mortgage payment you can afford.
You can calculate this number before talking to a lender so that there will be no surprises about how much you might expect to borrow. First, total all your monthly liabilities – including the potential housing payment - and divide that number by your gross monthly income. The resulting percentage is your DTI ratio. In order to qualify for a mortgage, your DTI must come in under a certain number. That number can vary depending on lender and loan program but is almost always lower than 50%.
The DTI is commonly broken into two parts: the front-end DTI and the back-end DTI. The typically maximum accepted front- and back-end ratio is 28/36.
The front-end DTI determines the impact your new mortgage payment will have on your monthly income. It is calculated by dividing your potential mortgage payment – including the taxes, insurance and any HOAs - by your gross monthly income. For most conventional, conforming loans this number should be lower than 28%. For example, let’s say your gross monthly income is $10,000 and your new payment will be $2,000. That would give you a front-end ratio of 20%, an acceptable rate for most underwriting standards. The lower the ratio, lenders figure, the more disposable income you will have to deal with life’s emergencies.
The last half of the DTI ratio takes into account all your other monthly debts. The back-end ratio is more important than the front-end ratio as it gives your lender a more complete picture of the total debt load you will carry once you begin your mortgage payments. To calculate the back-end ratio, figure out how much you pay monthly in total debt – student loans, car payments, credit card bills, other loans, etc. Add to this figure the proposed mortgage payment and then divide that total by your gross monthly income. If your potential mortgage payment is $2,000 and all your other monthly liabilities add up to $1,500, then you would divide $3,500 by your $10,000 gross monthly income to get a rate of 35%. Most lenders look for a maximum back end ratio of 36%.
Some lenders and digital underwriting systems will allow for greater DTIs if you have a large down payment, excellent credit or ample assets. Some government-backed loan programs, like FHA and VA loans, may also accept higher DTIs. On the other hand, if you want a conventional loan or are not planning to contribute much of a down payment or have poor credit, your lender may require an even lower DTI ratio. The DTI is all about determining how much of a risk you are as a borrower.
By calculating your debt-to-income ratio, you can give yourself a heads-up about how likely you are to qualify for a mortgage loan. If your DTI is not within typical bounds, you can work to reduce your monthly liabilities before applying and increase your chances of approval.