How to Maintain a Good Debt-to-Income Ratio
Your debt-to-income ratio can be pivotal in getting approved for a mortgage. That’s because even if you have a high income, your debt payments could make it difficult for you to pay your mortgage.
Lenders look at this ratio to gain more insight into your ability to repay a mortgage loan. But many home buyers don’t know what this crucial number is or how it works. Below we’ll explain how the debt-to-income (DTI) ratio works and how to improve it.
What Is a Debt-to-Income Ratio?
Your debt-to-income ratio shows how much debt payments claim from the money you make each month. This includes all kind of balances and loans, from revolving lines of credit (like credit cards) to installment loans (like a mortgage or a car loan).
Lenders look at your current debt-to-income ratio to help them understand how well you could manage a monthly mortgage payment. They also project what your debt-to-income ratio will be if they underwrite the home loan you apply for.
Calculate Your Own DTI
This is an important number to know for yourself before you go to a lender to request a mortgage. You can evaluate your own situation first, and get a better understanding of what you might need to do before buying a home.
First, tally up all your debts and liabilities that require you to make monthly payments. These include things like:
- Any loan payments you make (student loans, personal loans, car loans, etc.)
- Any payments you make toward credit card debt
- Any child support or alimony payments
- Any other debt you need to repay
Next, look at your gross monthly income. This is what you pay before retirement contributions, taxes, health insurance, or anything else withheld from your paycheck.
Then, divide your total monthly debt payments by your total gross income. The result is your debt-to-income ratio, and you write that number as a percentage.
We’ll use a salary of $50,000 to illustrate an example. Let’s assume you make this as your gross income. That breaks down to a little more than $4,166 per month.
Now let’s assume you have the following debts:
- $300 car payment
- $200 student loan payment
- $50 credit card payment
Your monthly payments toward your debt total $550. Divide that by $4,166, and you can see that your debt-to-income ratio is 13.2%.
What’s a Good Ratio to Have?
Experts recommend having a debt-to-income ratio below 43%, including your mortgage.
This puts your debts in a manageable range, where you can have a high likelihood of being able to pay them off. Most mortgage lenders won’t approve you for a qualified mortgage if your monthly payment will lift your debt-to-income ratio above 43%.
The higher your debt-to-income ratio without a mortgage, the more likely that you’ll struggle to make the monthly payments on your mortgage and/or existing debts.
Sticking with our earlier example, say you make $50,000 per year or $4,166 per month.
If you currently pay $208 per month toward a car payment, your DTI ratio is 5%. Adding in a mortgage payment of $1,250 per month would raise your ratio to 35%, which is considered perfectly acceptable by lenders.
If you also needed to make a student loan payment of $125, your debt-to-income ratio before a mortgage would rise to 8%. Adding in that $1,250 mortgage means your DTI would rise to 38% — a little high, but still below the limit of 43%.
How to Lower Your Debt-to-Income Ratio
Experts say that you should use no more than 33% of your gross income toward your housing expenses. That includes a mortgage and every other monthly cost you need to pay to maintain your home.
That means if your debt-to-income ratio is 10% or higher without a mortgage, adding on a home loan may push you above the amount of income you can use on debt and still qualify.
The good news is, you can take action to reduce your debt-to-income ratio before you talk to a lender about a mortgage:
- Create a repayment plan to tackle your existing debts. The debt avalanche is the mathematically superior way to pay back balances and loans, but the debt snowball provides quicker wins that may give you the motivation you need to keep working to repay everything.
- Consider consolidating and/or refinancing your current debts. This could lower your monthly payments — but beware of the downsides before you pursue this path. Refinancing means getting a brand-new loan with new terms, which means you could be paying your loans for longer (and therefore paying more interest in the long run). And when it comes to student loans, refinancing federal loans can make you ineligible for benefits and protections offered to federal borrowers.
- Avoid taking on any additional loans, balances, or debt.
Maintaining a Good DTI Ratio While Buying a Home
You can also keep a good debt-to-income ratio by changing some of the factors that influence how much money you want to borrow from a lender.
First, you could lower the amount of money you want to borrow. Borrowing less means a smaller monthly mortgage payment. That would leave you with a smaller DTI ratio than if you took out a larger mortgage.
Of course, that’s not always realistic (especially if you’re in competitive markets where homes easily sell in the $500,000 to $1,000,000 or more range). If you don’t want to back off your home-buying budget, consider putting more money into your down payment.
The larger your down payment, the less you need to finance. That also means a small mortgage payment and a lower debt-to-income ratio.
This is not necessarily easy to do, but you have a few options to put down a bigger down payment.
For example, you could use the Unison HomeBuyer program. With this program, Unison can provide up to half of your down payment without adding any monthly payments or interest charges. You can use the money until you sell the home – up to 30 years later.
No matter what, knowing your DTI and understanding how it can affect your home purchase, puts you a step ahead of the crowd when buying a home.