Is there anything better than getting a low interest rate on your mortgage? A low rate has the potential to save you thousands over the life of a loan. That's why those who are looking to get a mortgage work hard to set themselves up for success.
What's a great way to show lenders that you can manage money well and should be rewarded with competitive rates? Having a healthy debt-to-income (DTI) ratio.
Here, we'll go over just what DTI is, how to calculate it, how it affects your mortgage process, the percentage you should aim for, and how to improve your ratio, all so you can get great offers while rate shopping for a mortgage.
Never heard of DTI? You're not alone. It's not a term that typically comes up in your day-to-day, but you may hear it thrown around quite often once you become interested in purchasing a house.
Your debt-to-income ratio is how much you owe each month compared to how much money you earn per month, and is expressed as a percentage.
Calculate Your Debt-to-Income Ratio
To calculate your DTI, you first take what you earn every year before taxes and divide that number by 12 to get your monthly income amount.
Then add up your monthly debts - things like mortgage payments, child support, credit card payments - and from there, it's simple division.
(Monthly debt / monthly income) x 100 = your debt-to-income ratio
When you're buying a home, your mortgage underwriter may look at your front-end DTI and your back-end DTI, so it's important to know how those two percentages are different.
A borrower typically has a lower front-end ratio than a back-end, as it only considers the potential mortgage payment and no other debts. Let's say you earn $65,000 annually and you want to secure a mortgage that has monthly installments of $1,500. Using our formula, we can calculate the front-end DTI:
(1,500 / 5,417) x 100 = 27.7 percent
The back-end DTI takes into account all of a borrower's debts. Let's say that your monthly debt totals $2,200. Your back-end DTI would be:
(2,200 / 5,417) x 100 = 40.6 percent
Why DTI Matters in Mortgages
So, how does debt-to-income affect a mortgage? When dealing with large sums of money, a lender is very concerned about a borrower's money management skills. Having good management skills attests to the borrower's ability to stay on track with the terms of the loan agreement and keep up with monthly installments.
Your DTI is important because it provides some insight as to how you manage your money. In the eyes of a lender, a low DTI ratio makes you a less risky borrower. Therefore, if you're financially able to, it's wise to pay off large debts before you start the mortgage process.
With a low DTI, you're well-positioned to negotiate a low interest rate!
What Should Your DTI Be For a Mortgage?
Since DTI is an important factor when it comes to securing competitive mortgage terms, it's important to know what is considered to be a good DTI ratio. When referring to front-end ratios, lenders like to see no more than 28 percent.
According to Zillow.com, a back-end DTI ratio of 36 percent or less is considered ideal.
Because so many factors are taken into account when you're looking to buy a house, a higher percentage rate may not necessarily exclude you from obtaining a mortgage. If you're weak in some areas but very strong in others, the lender may be more flexible. That being said, it's always better to pay down your debts before buying a house, as homeownership comes with its own costs over the years and you don't want to get in over your head.
How Can You Improve Your DTI Ratio?
Now that you know how important your DTI ratio is when it comes time to secure a mortgage, you may be wondering how you can improve your percentage. There are two ways to do this. The first is to reduce your recurring debt. Easier said than done! You may be able to cut back on things that aren't vital, like dining out, and use that money toward a hefty credit card bill.
Creating a budget is a great way to see where your money is going and the areas you can reduce your spending.
The second way to lower your DTI percentage is by increasing your annual income. Again, much easier said than done. Many people choose to take up freelancing in their spare time or opt for a more stable part-time second job. Discussing a raise or logging overtime hours at your current place of employment if you qualify for them may be options as well.
A combination of these two methods would help lower your DTI ratio faster, so consider implementing both a budget and increasing your monthly income.
Remember, if the end goal is to purchase a house, avoid taking on more debt and instead focus on paying down current debts.
Does DTI Affect Credit Score?
Since your debt-to-income ratio deals with your income, which may fluctuate, it is not included on your credit report. Because of that, many borrowers mistakenly believe that it will not impact their ability to secure a mortgage, but that just isn't true. Your DTI is a part of your overall financial health. A lender will calculate your back-end DTI and may also look at your front-end ratio.
For that reason, it's a good idea to have a solid understanding of your finances. Map out your spending and stick to a budget long before you decide to purchase a house. By planning for the future and setting yourself up for success, you could potentially save thousands of dollars over the life of your mortgage.
Calculate Your DTI & Rate Shop Today!
LendGo's free online platform makes it easy for borrowers of all DTI ratios to explore their mortgage options. Don't hesitate to connect with reputable lenders today. You'll be in your dream home in no time!