What is a Debt-to-Income ratio?
A debt-to-income, also called your “DTI”, is a ratio derived by dividing your total monthly debt payments by your gross monthly income. The DTI ratio is expressed as a percentage lenders use to determine how well you manage your monthly debts — and if you can afford to repay a home loan.
Lenders look at borrowers with higher DTI ratios as riskier borrowers because they might run into trouble repaying their home loan in case of financial hardship.
To calculate your debt-to-income ratio, add up all of your monthly debts – rent or mortgage payments, student loans, personal loans, auto loans, credit card payments, child support, alimony, etc. Then divide the sum by your gross monthly income.
For example, if your monthly debt equals $2,500 and your gross monthly income is $7,000, your DTI ratio is about 36 percent. (2,500/7,000=0.357).
What factors make up a DTI ratio?
There are two factors lenders use for a DTI ratio: a front-end DTI ratio and a back-end DTI ratio. Here’s a look at each DTI factor and how they are calculated:
Front-end ratio, also sometimes called the housing ratio, shows what percentage of your gross monthly income would go toward your housing expenses, including your mortgage payment, real estate property taxes, homeowners propety insurance, and homeowners association dues (if applicable).
Back-end ratio shows what portion of your gross income is needed to cover all of your monthly credit / debt obligations, plus your total mortgage payments. This includes your credit card bills, car loans, child support, student loans and any other revolving debt that shows on your credit report.
How is the debt-to-income ratio calculated?
Here’s a simple formula for calculating your DTI ratios. Add up all of your monthly debts. These payments may include:
• Monthly mortgage or rent payment
• Minimum credit card payments
• Auto, student or personal loan payments
• Monthly alimony or child support payments
• Any other debt payments that show on your credit report
Divide the sum of your monthly debts by your gross monthly gross income (your take-home pay before taxes and other monthly deductions).
Convert the figure into a percentage and that is your DTI ratio.
Keep in mind that other monthly bills and obligations — utilities, groceries, insurance premiums, healthcare expenses, daycare, etc. — are not part of the DTI calculation. Your lender isn’t going to factor these expense items into their decision on how much money to lend.
What is an ideal debt-to-income ratio?
Lender’s underwriting guidelines indicate the ideal front-end ratio is usually no more than 28 percent, and the back-end ratio, including all expenses, is usually around 36 percent or lower. In reality, depending on your credit score, amount of savings in the bank, and your down payment amount, lenders usually accept higher DTI ratios, depending on the type of loan you’re applying for.
For FHA and some conventioal home loans, lenders now accept a back-end DTI ratio as high as 50%. That means 50% of your gross monthly income is going toward your housing expenses and recurring monthly debt.