Why is DTI important?
DTI is an important factor in determining whether you can obtain a loan. Simply put, the higher the percentage of your income that goes toward paying debt each month, the higher the risk that you may not be able to pay your mortgage each month. The opposite is true as well: The lower your DTI, the lower the risk there is that you might default on your mortgage loan. Lenders prefer a DTI ratio of 43%, but there are exceptions. For example, other factors may allow for a larger DTI like a high credit score, your down payment, and your assets. Below are the maximum DTIs for each type of loan.
What is considered debt?
When we say debt, we’re not talking about living expenses that may change from month to month. We’re talking about your credit card debt, student loans, other loans, and mortgage or rent.
How do you calculate your DTI?
Add up all your monthly debt payments and divide the total by your gross (pre-tax) monthly income then multiply by 100 and that’s your debt-to-income ratio. If you don’t know your gross monthly income, simply take your annual income (pre-tax) and divide by 12.
Let’s look at an example:
Joe’s and Lucy’s monthly debt includes:
$500 – credit cards
$2100 –current mortgage or rent
$500 – student loans
$300 – car loan
Their total monthly debt = $3400. Their gross monthly income is $8,000
3400/8,000 = .425 x 100 = DTI of 42.5% (round up to 43%)
43% of their monthly income goes toward paying debt.
Although DTI doesn’t take into consideration your other monthly expense (i.e., food, medical, electric, entertainment, home maintenance, furniture), that doesn’t mean you shouldn’t keep these in mind when pricing homes. As you consider how much home you can afford, consider your entire household budget. The last thing you want is to end up with a home you can’t maintain.
If you DTI is high, look for ways to start paying off your debt. One popular approach is to pay off the credit card with the lowest balance first. This is known as the “snowball” method. It gives you a sense of progress and accomplishment and the momentum you need to keep moving forward. The opposite approach is the debt “avalanche” method which pays off credit cards with the highest interest rate first in an effort to save the money you would have paid toward interest.
DTI is a critical part of the loan process. Stay on top of yours, and you’ll find you have more options when it comes to obtaining a mortgage.