Debt-to-income (DTI) is used to compare your monthly debt payments to your monthly gross income. Lenders use this number to assess your ability to manage monthly payments and repay debts, i.e. your borrowing risk.
It also gives you an idea of how much house you can afford as you begin your home search. Whether you’re going after a $300k home or a $500k home, knowing your DTI empowers you as a buyer!
Why is DTI Important in a Home Purchase?
As a key part of a mortgage pre-approval, your DTI helps lenders assess whether you will be able to pay back your loan. In general, the lower your DTI, the better when it comes to getting a mortgage.
A low DTI shows that you manage existing debt responsibly, and are likely to pay off your mortgage in the same manner. On the other hand, if you have a high DTI, you might not be able to secure a loan, which limits your purchase power as a homebuyer.
How to Calculate Your Debt-to-Income Ratio
- Add Your Monthly Expenses Together
To calculate your debt to income ratio, add up your required minimum monthly payments, the only debts to include when calculating your DTI are those that appear on your credit report.
What to Include:
- Rent or monthly mortgage payments
- Auto loan payments
- Student loan installments
- Child support or alimony obligations
- Credit card payments
- Personal loan paymentsÂ
- Monthly homeowners association (HOA) fees
- Property taxes
- Homeowners insurance payments
What to Exclude:
- Utility costs
- Health insurance costs
- Transportation expenses
- Food, entertainment, clothing, and leisure purchases
- Contributions to savings accounts
- 401(k) or IRA contributions
2. Divide This Number By Your Gross Monthly Income
Gross monthly income refers to your pretax income each month. For example, if you have a $48,000 salary, your gross monthly income is $4,000. Now, divide your monthly expenses by this number. So, if your monthly expenses are $1,000, you would divide 1,000 by 4,000 = .25.
3. Multiply by 100
Next, take this number and multiply it by 100 to get your DTI ratio as a percentage. Using the same example, your DTI ratio would be .25 x 100 = 25%.Â
The 28/36 rule on DTI
Use the 28/36 rule as a gauge to understand your debt-to-income. This rule provides a guide for how much debt a household can safely take on. Here’s what each number means:
- 28: No more than 28% of your gross monthly income should be allocated to housing expenses, including mortgage payments, property taxes, insurance, and HOA fees.
- 36: No more than 36% of your gross monthly income should go to paying off all debt, which includes housing expenses, credit cards, and auto loans.
What the Debt-to-Income Ratio Requirements Are for Different Loans
- Conventional Loan: Typically a DTI for a conventional loan can be no more than 45%, but some lenders will accept up to 50%. This depends on factors like a savings account, which should have enough to pay for at least six months’ worth of housing expenses.
- FHA Loan: The FHA requirement is less strict, and depends on the lender. The maximum DTI ratio allowed for an FHA loan is typically between 43% to 50%.
- USDA Loan: A DTI of no more than 41% is required for automatic approvals on a USDA loan, but this can stretch to 44% with manual underwriting.
- VA Loan: There is no maximum limit for a VA loan, but a DTI lower than 41% is the norm.Â
How to Lower DTI
Here are some of the common ways to lower your DTI:
- Pay off debt, starting with high-interest debt
- Refinance or consolidate debts
- Add co-borrower
- Avoid new loans, like auto
- Fully pay off your credit cards each monthÂ
- Negotiate lower interest rates
- Earn more income
If you are eager to purchase a home and are having difficulty lowering your DTI, you could consider more aggressive methods like selling a car to drop a car payment and ride-sharing with a spouse instead. If you have a 401k, you might consider loaning out or cashing out a portion to pay off debt.
Personal finances are unique to each individual, evaluate your situation and resources to find a strategy that works for you!
Our Resources Are Here To Help
The first step in dealing with a high DTI is pinpointing what it causing it. From there, you can make a plan to tackle your debt and lower your ratio before putting in an offer on a home.
For all your home buying and selling questions, check out our archive of helpful articles. Whether you’re a first-time or repeat buyer, we explain the nitty gritty so you know you’re covered in every circumstance.
