What is debt-to-income ratio and how does it affect your mortgage application?

If you’re dreaming of becoming a homeowner, you’ve probably already done some research on houses you like and investigated what you can afford. But before you jump into the homebuying process and apply for a mortgage, you’ll want to take a closer look at your finances. One important factor to consider before you apply for a mortgage is your debt-to-income ratio (DTI).

Your DTI plays a role in what your mortgage interest rate will be, and even whether you qualify for a mortgage at all. In competitive housing markets like Chicago, it’s important to know your DTI before you start shopping for a home.

Learn about your DTI and how it affects your mortgage application, and get tips for improving yours so you can buy the home of your dreams.

What is debt-to-income ratio?

Your debt-to-income ratio plays a big role in whether you qualify for a mortgage. Your DTI is the percentage of your income that goes toward your debt. In other words, it tells lenders how much you spend each month paying off your debts, compared to how much you earn.

Your DTI helps lenders assess how much risk they’d take on by lending money to you. And that in turn helps determine how much money you can borrow for your mortgage. A lower DTI is better, as lenders assume applicants with a lower DTI are more likely to be able to cover their mortgage payments each month.

While your DTI isn’t the only factor lenders look at as part of your mortgage application, it plays an important part, along with your credit score, job history and down payment.

How to calculate debt-to-income ratio

Figuring out your DTI requires a straightforward calculation. You’ll just need to divide your monthly debt obligations (like credit card and loan payments) by your monthly gross income (or your income before taxes).

Here are some common obligations to include in your calculation:

• Credit card payments (use your minimum payment)
• Rent or mortgage payments
• Car payments
• Student loans
• Personal loans
• Home Equity Line of Credit (HELOC)
• Child support / alimony payments

So, let’s say your monthly gross income is $5,000. And you have a rent payment of $1,200, a car payment of $400 per month, along with a minimum credit card payment of $200. Your total monthly debts are $1,800.

1,800 / 5,000 is 36% of your income, so your debt-to-income ratio is 36%.

Generally speaking, lenders require a DTI of 43% or less (depending on your credit score) to approve a mortgage, according to the Consumer Finance Bureau .

It’s important to remember that DTI is just a measurement that banks use to assess your ability to make your payments. You’ll also want to make sure you’re comfortable making your mortgage payments regardless of your DTI.

A good way to test how comfortable you’d be with your potential payment amount is to calculate what your DTI would look like based on net income rather than gross. Since you probably have money taken off your paycheck for things like taxes, health insurance, a 401k and more, calculating how much of your take-home pay goes toward your debts can give you a more accurate idea of how much house you can afford.

The different types of debt-to-income ratio

There are two types of debt-to-income ratio, front end and back end, and most lenders will look at both. The more important of the two is the back-end DTI, because it gives a more complete picture of how much you owe and how much you spend on your debts each month. A front-end DTI, on the other hand, looks strictly at your housing expenses.

Front-end debt-to-income ratio

Your front-end DTI (also called a household DTI) is a variation of the debt-to-income ratio that looks specifically at your housing-related obligations. The front-end DTI shows how much of your gross income goes toward housing costs. It’s calculated by taking your housing expenses and dividing that figure by your gross income.

Here are common examples of debts that are included in your front-end DTI:

• Rent or mortgage payments
• Homeowners insurance premium
• Homeowners association fees
• Mortgage insurance
• Property taxes

Back-end debt-to-income ratio

Your back-end DTI (also called the total debt ratio) includes all your debt obligations, not just your housing-related costs. If you have student loans, a car loan, credit card debt or a line of credit balance, all those debts will factor in to your back-end DTI, on top of any housing debts. Because your back-end DTI takes into account all these other types of debts, it’s usually higher than your front-end DTI.

In addition to the debts that are included in your front-end DTI, your back-end DTI also includes:

• Credit card payments (use your minimum payment)

• Car payments

• Student loans

• Personal loans

• Home Equity Line of Credit (HELOC)

• Child support / alimony payments

Tips for lowering your DTI to help you get approved for a mortgage

If you’ve calculated your DTI and find it’s higher than you’d like, don’t worry. There are steps you can take to lower your DTI, which can help you get approved for a mortgage and maybe even land a lower interest rate.

Here are our top tips for lowering your DTI before applying for a mortgage:

• Increase your monthly debt payments:

  If you can afford to do so, bumping up the payment amounts on your debts can help lower your DTI over time. Think about it as short-term pain for long-term gain. Even if you put an extra $100 toward debt each month, you’ll soon find your DTI will drop.

• Don’t take on new debt:

  If you were thinking of buying a new car and taking out a loan, you may want to hold off for now and instead focus on paying for your future mortgage. Avoiding new debt means your DTI won’t go up.

• Put down the credit card:

  If you’re able to, pay for any big-ticket purchases you’ve been planning with cash, rather than paying the cost off slowly by putting it on your credit card. Carrying a larger credit card balance will raise your DTI.

• Put your spouse on your loan application:

  If you’re planning to buy a new home with your spouse, you can include them on your loan if they carry less debt than you do. If your partner’s DTI is lower than yours, adding them to your loan application will help lower your overall DTI. But if their DTI is the same or higher, this approach unfortunately won’t help with lowering the DTI on your mortgage application.

Buying a new house is an exciting experience, and the more you plan ahead for the homebuying journey, the smoother the process will be. Before you apply for a mortgage, calculate your debt-to-income ratio to get a better sense of how you look to potential lenders.

The more you know about your finances and how they affect your mortgage approval, the more empowered you’ll be to put your best foot forward when you’re ready to make the move and apply for a mortgage.