Why Your Debt-to-Income Ratio Matters for Your Mortgage

Highlights:

• Your debt-to-income (DTI) ratio refers to the total amount of debt payments you owe every month divided by your gross monthly income.
• Mortgage lenders may consider your DTI ratio as one factor when determining whether to lend you money and at what interest rate.
• The DTI ratio you'll need to secure a mortgage will ultimately depend on your lender. However, lenders typically prefer a DTI ratio of 36% or below.

If you plan to work toward homeownership, you'll need to understand your debt-to-income (DTI) ratio. Mortgage lenders may consider your DTI ratio as one factor when determining whether to lend you money and at what interest rate.

Here's what you need to know about this little number that packs a big punch.

What is your DTI ratio?

Your DTI ratio refers to the total amount of debt payments you owe every month divided by your gross monthly income. Your DTI ratio is expressed as a percentage.

For example, if your DTI ratio is 50%, then half of your monthly earnings are being used to pay your credit cards, student loans and other debts.

How to calculate your DTI ratio

To find your own DTI ratio, total your monthly debt payments, including installment loans, credit card minimum payments, medical bills and any other debt you owe, such as rent or child support.

Next, determine your gross monthly income, or how much money you earn before taxes and deductions are taken out.

Finally, divide your total monthly debt payments by your gross monthly income and multiply by 100.

For example, say you make $2,000 every month. At the same time, you pay $100 in credit card debt, $100 toward your car loan and $300 toward your student loans for a total debt load of $500 per month. To calculate your DTI ratio, first divide 500 by 2,000. Then multiply the result, 0.25, by 100 to convert it into a percentage, which leaves you with a DTI ratio of 25%.

Why does your mortgage lender care about your DTI ratio?

Your DTI ratio is one tool that lenders use to measure your creditworthiness, or the likelihood that you'll pay back credit extended to you. Mortgage lenders may consider your DTI ratio when determining whether to approve your mortgage and when setting your interest rate.

Generally speaking, mortgage applicants with low DTI ratios pose less risk to lenders and are more likely to be approved for a loan. In other words, borrowers with lower DTI ratios pay less toward their debts each month and, in turn, have more income to put toward new financial commitments.

A high DTI ratio, however, may suggest to a lender that you have excessive debt relative to your earnings. In many cases, a high DTI ratio can be a warning sign that you don't have the income to spare on new debt. As a result, borrowers with high DTI ratios may struggle to be approved for a loan or face steep interest rates.

What is a good DTI ratio for a mortgage?

The DTI ratio you'll need to secure a mortgage will ultimately depend on your individual lender. However, most lenders prefer a DTI ratio of 36% or below. Keeping your DTI ratio at or below this level can improve your chances of being approved for a mortgage.

Depending on the type of mortgage you apply for, some lenders will accept a DTI ratio as high as 43%. However, lower DTI ratios generally increase your chances of approval and lead to a lower interest rate.

How to lower your DTI ratio

If your DTI ratio isn't where you need it to be as you begin the homebuying process, these strategies might help:

• Pay off as much of your debt as possible. The easiest way to lower your DTI ratio is to reduce your monthly debt payments. Aim to pay off any outstanding balance on your credit cards. When it comes to installment loans, some borrowers like the momentum they feel with the snowball method. This approach involves paying more than the monthly minimum toward your loan with the lowest principal so that you pay it off first. You then shift your focus to the next smallest debt until all your loans are paid in full.
• Avoid applying for new lines of credit. Delay opening additional credit cards or loans until after the homebuying process is complete.
• Look for a way to increase your monthly income. You can also cut your DTI by increasing the amount of income you bring in each month. If a salary increase is out of the question, you might try to supplement your regular income with a part-time job or freelance work.

As you work to lower your DTI ratio, keep the goal of 36% in mind. Remember: applicants with a DTI ratio of 36% or less are the most likely to be offered a mortgage, bringing dreams of homeownership one step closer to reality.