Debt-to-Income Ratio: What It Is and Why It Matters
Published on August 28, 2024 | 4 Minute read
Melanie
Ortiz Reyes
Content Specialist
When you're getting ready to apply for a mortgage, one of the terms you'll frequently come across is the "debt-to-income ratio," or DTI. It might sound like just another piece of financial jargon, but understanding your DTI is crucial if you want to get the keys to your dream home.
So, what exactly is the debt-to-income ratio? Simply put, your DTI is the percentage of your monthly income that goes toward paying your debts. Lenders use this ratio to evaluate whether you can afford to take on a mortgage while managing your other financial responsibilities.
Why Does the Debt-to-Income Ratio Matter?
Imagine you’re about to lend a significant amount of money to someone. You’d want to be sure that they can handle the payments, right? That’s exactly what lenders are thinking when they look at your DTI. A lower ratio suggests that you’re not overburdened by debt, making you a less risky borrower. On the other hand, a higher DTI might signal that you’re already stretched thin financially, which could make lenders hesitant to approve your mortgage.
Calculating Your Debt-to-Income Ratio
Calculating your DTI isn’t rocket science. All you need to do is add up your monthly debt payments. This includes things like credit card bills, student loans, car payments, and any other regular debt obligations. Then, divide this total by your gross monthly income (that’s your income before taxes and other deductions). Multiply the result by 100, and you have your DTI.
For example, let’s say you pay $500 per month on a car loan, $300 on student loans, and $200 on credit cards. Your total monthly debt payments would be $1,000. If your gross monthly income is $5,000, your DTI would be 20%, which is a pretty solid number.
What’s a Good Debt-to-Income Ratio?
When it comes to DTI, lower is better, but what’s considered “good”? Generally, lenders prefer to see a DTI of 36% or lower, with no more than 28% of that going toward your mortgage payment. This is often referred to as the “28/36 rule” in the mortgage world.
However, these numbers aren’t set in stone. Some lenders might be willing to work with borrowers who have a higher DTI, especially if they have other factors working in their favor, like a high credit score or a hefty down payment.
How to Lower Your Debt-to-Income Ratio
If your DTI is higher than you’d like, don’t worry, there are steps you can take to bring it down before applying for a mortgage:
1. Pay Down Existing Debt: Focus on paying off high-interest debt like credit cards first. Every dollar you can knock off your monthly payments helps reduce your DTI.
2. Increase Your Income: This might sound easier said than done, but even a small increase in your monthly income can make a difference. Consider taking on a side gig or asking for a raise at work.
3. Avoid Taking on New Debt: Now is not the time to finance a new car or open a bunch of credit cards. Try to keep your debt levels steady or decreasing as you prepare to apply for a mortgage.
4. Reassess Your Budget: Take a close look at your budget to see where you can cut back on discretionary spending. Redirecting those savings toward paying down debt can help lower your DTI.
The Bottom Line
Your debt-to-income ratio is a key factor that lenders use to determine your mortgage eligibility. By understanding what your DTI is, why it matters, and how to manage it, you can position yourself as a stronger candidate for a mortgage. So, before you start house hunting in earnest, take a moment to calculate your DTI and see where you stand. If it’s higher than you’d like, don’t panic. Use the strategies above to bring it down and improve your chances of getting approved for the home loan you want. After all, the road to homeownership is much smoother when you’re financially prepared.