Are you thinking about buying a home and need to apply for a mortgage? Before you can get approved for a mortgage, you'll need to get familiar with your debt to income ratio (DTI). This mortgage term may seem a bit daunting and unfamiliar, but once you understand it's meaning and importance in helping you get a home loan, you'll be glad you took the time to learn more about it.
When your ready to look for a home to buy, you'll need to get pre-approved for a home loan (unless you're paying all cash). Part of the process of getting a home loan is determining your DTI. The basic premise of your DTI ratio is the comparison between how much you owe each month (debts) vs. how much you earn (gross monthly income). Your gross monthly income includes everything from money you earn before taxes (paycheck and investments), health insurance and retirement contributions and possibly other deductions. Your debts might include the boat and camper you're making payments on along with credit card debt. Lenders look at past and current finances to determine whether or not you qualify for a mortgage. If you aren't in a good financial position, you can work to improve your DTI and eventually qualify for a mortgage.
DTI = Monthly Debt Payments / Gross Monthly Income
Many loans require your DTI to be < 43% of your income which, in the eyes of your lender, makes it less likely you'll have a problem paying your mortgage each month. A score of 20% is considered low and most favorable. If your DTI score is unfavorably high, a good credit score (FICO) may override it allowing you to qualify for certain types of loans (ex. USDA).
Front-End DTI
Your front-end ratio refers to how much of your pretax income would go toward your mortgage payment, property taxes, homeowner insurance and other related expenses. Lenders prefer your front-end DTI ratio to be below 28%. Higher percentages would indicate you would not be able to afford a monthly mortgage payment.
Back-End DTI
When lenders calculate back-end DTI they're looking at all of your debts with a monthly mortgage payment added in, compared to your pre-tax income, to determine if you can afford a mortgage. A high back-end DTI would indicate that you wouldn't be able to afford a monthly mortgage payment on top of other debts and daily expenses.
Lowering Your DTI
One of the best ways to lower your DTI is to increase your income. This might mean taking on a part-time job or asking for a raise at your current job. Paying down debt is also a good way to lower DTI. Look at where you could cut expenses (ex. clothes, eating out, hobbies) and use that money to make extra payments on your credit card, for example. Just as important, don't make any large purchases, sign up for new credit cards or take on any new loans.
Conclusion
When you have a low DTI ratio, your lender will view you as someone who has control of their finances and able to handle a monthly mortgage payment. Talk to your lender about how your DTI ratio will affect your ability to get a mortgage. If you don't qualify for a loan, find a part-time job to earn more money and cut unnecessary expenses to pay down your debt faster. Before you know it, you'll qualify for a mortgage loan, with a low DTI ratio, and you'll be on your way to owning a home.