The banking industry is populated by numbers types, the kind of people who score and rank everything, who don't believe something is real unless it is assigned a number, who gaze at spreadsheets as if they are crystal balls. So it's no wonder that a single number assigned to you plays such an important part when you try to borrow a lot of money.
One of the factors that lenders use to determine whether to grant you a new mortgage or let you refinance a current mortgage is your debt-to-income ratio. If it sounds complicated, it's not. In fact, DTI is one of the easier lending concepts to grasp. And you can calculate yours quickly, no business degree required. You don't even need a spreadsheet.
Here is how to figure your DTI in three easy steps.
1️⃣ Add Up All Your Monthly Debt Payments
Bring up the transaction history of your checking account, and jot down all the debts you repay regularly and how much. It doesn't matter what each account balance is; what matters is your regular cash outlay to pay down each debt.
If you pay a credit card balance in fully every month (think AmEx) before the balance has a chance to become debt and accrue interest, that payment doesn't count. You're using the card as floating cash, a smart strategy that saves cardholders a lot of money. A pat on the back to you!
"Do I include the rent I currently pay?"
No, not if the purpose of your loan is to buy a primary residence and kiss renting goodbye. If that's the case, however, you do need to include the estimated mortgage payment that will replace your rent payment.
Use an easy calculator to estimate what your mortage payment would be along with the extras that, as a renter, you didn't have to worry about, such as property taxes, private mortgage insurance, homeowners insurance, and HOA fees.
Here is an example.
Monthly Debt Repayments
|Capitol One card||$100|
2️⃣ Add Up Your Monthly Income Before Taxes
You will need paystubs for this step, not your checking account transaction history. That's because you need to add up your monthly pay before taxes and deductions. It's your gross income that matters. In other words, how much you earn, not how much you take home.
Why isn't net income used in DTI?
Because gross income is the more dependable/stable number available for lenders' use. Your net income is affected by many factors that you control, like the dependents you declare or your contribution to a 401(k). This isn't true for gross income.
If you have irregular income, such as from a bonus at the office or a side hustle that heats up in summer and cools off in winter, a lender will allow you to count this as monthly income so long as the income is reliable. To prove reliability, lenders will want to see tax returns from the last two years, possibly earlier. Irregular but reliable annual income should be divided by 12 to derive average monthly income from that source.
For our example, we will use $5,720 as monthly income.
3️⃣ Divide Your Monthly Debt Repayments by Your Income
"Hey, Cortana, open calculator." Add up your monthly payments, then divide it by your monthly income.
DTI = Monthly Debt Payments ÷ Monthly Income
45% = $2,576 ÷ $5,720
Is 45% a good DTI? It's pretty good. Mortgage qualification is based on many factors, with DTI being one. Other factors include credit score, loan type, down payment, and marital status. Generally, in order to qualify for most mortgage loan options, you will want a DTI no higher than 43%.
Fortunately, you control most of the variables in your DTI, and you can lower it with a little patience or budgeting. In our example, your DTI would improve to an enviable 38% once the car is paid off. Therefore, postponing your house hunt until the car is paid off could earn you a lower interest rate that could save you tens of thousands of dollars over the life of the mortgage.
"When planning finances, individuals should always prioritize managing their current debt over any other financial decisions. Maintaining an ideal debt-to-income ratio is an essential parameter to check when managing loans and advances," says former financial advisor Vipin Sharma.
Different Loans Have Different DTI Levels
Your DTI sweet spot will vary depending on the type of loan you seek: car, homebuying, refinance, boat, business, and so on. In all cases, a lower DTI is better than a higher one, but each lender sets its own definition of low, medium, and high and will offer you a rate based on that determination.
That's why it is important to compare multiple lenders. At one lender, your DTI may be considered low, qualifying you for a lower interest rate than you can get at the lender who places your DTI inside medium territory.