If you're applying for a mortgage to buy a home, having too much debt can make it challenging to get approved for the loan. When reviewing your finances to determine whether you can afford the new mortgage payment, you must also factor in your existing debt payments.
As a result, you need to calculate your debt-to-income ratio, or DTI, which represents the percentage of your monthly income that goes to making debt payments, such as loans and credit cards. Your debt-to-income ratio is an important metric when trying to line up financing to purchase a home, as it is used to determine mortgage affordability.
Once financing has been obtained, few homeowners give the debt-to-income ratio much further thought but perhaps they should, as a change to income or addition of new debt can affect one's ability to service existing debt.Our mortgage calculator is a useful tool tohelp estimate monthly payments. In this article, we will show you how the DTI ratio is used.
Key Takeaways
- Having too much debt can make it challenging to get approved for a mortgage loan.
- Your debt-to-income ratio (DTI) compares the amount of total debts and obligations you have to your overall income.
- Lenders look at DTI when deciding whether or not to extend credit to a potential borrower and at what rates.
- A good DTI is considered to be below 36%, and anything above 43% may preclude you from getting a loan.
Calculating Debt-to-Income Ratio
Calculating your debt-to-income ratio is straightforward. Total all of your monthly debt payments and divide that number by your monthly gross income, which is your income before taxes have been deducted.
To have a precise measurement, it's important to include all of the amounts of money spent each month servicing debt, including all recurring debt, such as mortgages, car loans, child support payments, and credit card payments.
Example of a Debt-to-Income Ratio
Let's say you have the following monthly gross income and debt payments:
- Gross income: $4,000
- Auto loan: $400
- Credit Cards: $250
- Student loan: $400
Total monthly debt payments = $1,050.
- Divide total debt by gross income: $1,050 / $4,000
- Debt-to-income ratio = .26 or 26%.
When calculating your debt-to-income ratio, you typically don't count monthly household expenses such as food, entertainment, and utilities.
Housing Expense Ratio
Another ratio to consider is the housing-expense ratio, which compares your gross income to all of the housing expenses, which includes your mortgage payment, home insurance, taxes, and any other housing-related expenses. To calculate the housing-expense ratio, total your housing expenses and divide it by your gross monthly income.
For example, let's say you earn $4,000 per month and have a mortgage expense of $400, taxes of $200, and insurance expenses of $150. Your total housing expenses would be $750 and divided by $4,000 would yield a housing-expense ratio of 19%.
Typically, mortgage lenders want to see a housing expense ratio of less 28%.A mortgage calculator can be a good resource to budget for the monthly cost of your payment.
Don't confuse your debt-to-income ratio with yourdebt-to-limit ratio. Also known as your credit utilization ratio, this percentage compares the sum of a borrower's outstanding credit card balances to their credit card limits (that is, all their total available credit). The DTL ratio indicates to what extent you're maxing out your credit cards, whereas the DTI ratio calculates your monthly debt payments as compared to your monthly earnings and other income. Since your DTL ratio affects your credit score, mortgage lenders may look at it as well.
Gross vs. Net Income
For lending purposes, the debt-to-income calculation is usually based on gross income. Gross income is a before-tax calculation, meaning it's before income taxes have been deducted from your pay. Since we don't get to keep all of our gross income (in most cases), we can't spend that money since you never actually receive it.
For example, let's say that you earn $2,000 per month in gross income, and after income taxes have been deducted, your net income is $1,700. If gross income is used in calculating your debt-to-income ratio, $300 of extra income is used to determine your spending ability. However, that $300 won't actually be available to pay your bills.
Also, net income (your take-home pay) will always be less than the number used in the DTI calculation. If you are in a higher income bracket, the percentage of your net income lost to taxes will be even higher.
Regardless of your tax bracket, you'll almost certainly be better served by using net income or the more conservative approach when calculating your debt-to-income ratio. Using the net number provides a much more realistic picture of how much of your income is being spent on debt and your ability take on new debt.
Good and Bad Numbers
Your debt-to-income ratio tells you a lot about the state of your financial health. Lower numbers are indicative of a better financial scenario since you have more monthly income available to afford a new debt, such as a mortgage payment. Unfortunately, a high debt-to-income ratio often means that there isn't enough extra income left over after paying your bills to take on new debt.
What Is a Good Debt-to-Income Ratio?
A good debt-to-income ratio is usually 36% or lower, with no more than 28% of that debt dedicated toward servicing the mortgage on your home. A debt-to-income ratio of 37% to 43% is often viewed as an upper limit, although some specialty lenders will permit ratios in that range or higher.
Fannie Mae, in some cases, will back loans extended to borrowers with DTIs of up to 50%, for example, if they meet certain credit score and cash reserve requirements.
Note that if such lenders are willing to give you the loan, that doesn't mean that you should take it. Nearly all experts agree that a debt-to-income ratio above 50% is living dangerously, but for many people, the best ratio is as close to 0% as possible, a number that represents debt-free living.
Monitoring Your Debt, Income, and Spending
While everyone has bills to pay and most of us have at least some recurring debt, unless your income source is unlimited and guaranteed, a lower debt-to-income ratio is almost always better than a higher ratio.
Want to lower—that is, improve—your debt-to-income ratio? Basically, there are two ways:
- Reduce your monthly recurring debt
- Increase your gross monthly income
Easier said than done, admittedly. Of course, you can also try a combination of the two.
Monitoring your debt-to-income ratio is a great way to keep tabs on your expenses and your buying power. Regardless of whether you earn $25,000 a year, $100,000 a year, or $1 million a year, your debt-to-income ratio provides a snapshot of your spending habits.
It's possible to have a small income yet, courtesy of good spending habits, budgeting, and a low debt-to-income ratio. It's also possible to have a high income but poor spending habits, resulting in a high debt-to-income ratio, particularly if you consistently spend beyond your means.
What Is a Good Debt-to-income Ratio?
A maximum debt-to-income ratio of 36% is usually preferred by lenders. A debt-to-income ratio of 37% to 43% is often viewed as an upper limit, although Fannie Mae may insure loans to borrowers with DTIs of up to 50%.
What Is the Housing Expense Ratio?
The housing expense ratio compares your monthly gross income to all of the housing expenses, such as your mortgage payment, home insurance, and taxes. Calculate your housing-expense ratio by totaling your housing expenses and dividing them by your gross monthly income.
What Is the 28/36 rule for Housing Expenses?
The 28/36 rule for housing expenses says that no more than 28% of your gross monthly income should go to your housing payment (like rent or mortgage payment) and no more than 36% of your gross income to paying total debt, such as your loans and credit cards.
The Bottom Line
The more debt you incur, either through housing or recurring debts, the higher your debt-to-income ratio. The higher your ratio, the more likely you are to be in financial difficulty. To make sure you're on the path to financial freedom, you can calculate this ratio each quarter to keep your finances moving in the right direction. If your debt-to-income ratio doesn't paint the picture of economic health that you'd prefer to see, you'll need to take steps toget your finances in order.
