If you’re in the market for a new property, it’s important to familiarize yourself with the term debt-to-income ratio (DTI). This ratio can significantly impact your ability to qualify for a mortgage, so it’s crucial to know where you stand. By calculating your DTI, you can better understand how to move forward with purchasing a property.
What is debt-to-income ratio?
Your DTI measures the amount of money you spend each month paying off your debts in relation to your monthly gross income. This ratio gives lenders insight into your financial capacity to handle your mortgage and other debts. Lenders need to ensure that you can make your monthly payments on time.
Back-end and front-end DTI
There are two types of DTI to consider: back-end and front-end.
Front-end DTI focuses solely on housing-related expenses. This ratio is calculated by adding up your monthly mortgage payment, mortgage insurance, property taxes, and HOA fees (if applicable), and then dividing the total by your gross monthly income.
Back-end DTI measures the percentage of your monthly gross income that goes toward all your additional debts. These debts include any outstanding loans, such as student loans, credit card debt, car loans, back taxes, alimony, child support, and personal loans.
Lenders typically prefer DTIs lower than 30 percent, although exceptions can be made on a case-by-case basis. A higher DTI percentage signals to lenders that your financial resources may be stretched too thin, which could affect your ability to make your monthly mortgage payments.
How to calculate your DTI
To calculate your DTI, add up all your recurring monthly debt payments, including your mortgage (if you currently have one), HOA fees, car loan, student loans, child support, alimony, credit card payments, and any other personal loans. Once you have totaled these expenses, divide the sum by your gross monthly income (pre-taxed income). Multiply this number by 100 to get your DTI percentage.
You can improve your DTI by paying off existing debts or reducing your monthly housing expenses. Reducing your DTI can help you qualify for a better mortgage rate. If reducing your DTI isn’t possible, consider finding a co-signer. However, be aware that your cosigner will share in the consequences if payments are not made in full and on time.