If you’re shopping for a new mortgage, you may have heard of the debt-to-income ratio. So, what is it and why does it affect your mortgage? We have all your questions answered. From how to calculate and improve your ratio to the steps you need to take to get your mortgage, we’ll go over everything you need to know about debt-to-income ratios.
What is Debt-to-Income Ratio (DTI)?
Your debt-to-income ratio is an important factor in getting your mortgage. This ratio refers to the amount of debt you have compared to your gross income. Your gross income is what you’re making before taxes, and any other retirement contributions or deductions come out.
The debt that factors into your ratio will typically include your car loan or lease payment, student loan payments, minimum credit card payments, personal loans, and any child support or alimony payments you may have. Lenders use this ratio to calculate your ability to take on more debt. Too much debt could signify you’re spending more than you’re making. This would make it difficult for you to afford a monthly mortgage payment, for example, on top of your other obligations.
How Does DTI Apply to Mortgages?
Almost any lender uses your debt-to-income ratio to determine how much of a loan you’re qualified for. The ratio can be used for car loans, student loans, personal loans, and mortgages. When it comes to your mortgage, your lender wants to see how much mortgage you can afford to pay each month. With a high debt-to-income ratio, this could signify you’re stretched too thin. A high debt-to-income ratio signals more risk to a lender. For example, if you’re spending almost all your income on your minimum credit card payments and car payments, this doesn’t leave much room to pay your mortgage.
Lenders want to see a low ratio for several reasons. Most importantly, a low ratio signals less risk. They will feel more confident that you won’t miss your mortgage payments. A high debt-to-income ratio shows lenders that there’s more of a chance, you’re spread too thin to make your payments each month. While this doesn’t mean you won’t qualify for a mortgage at all, you may just be eligible for a lower amount. This is where a higher down payment may help you buy a higher-priced home with a high debt-to-income ratio.
How to Calculate DTI
To calculate your DTI, you’ll start by writing down your gross monthly income. Next, list out all your monthly debt payments. This will include student loan payments, car loan payments, and the minimum payment on your credit cards. You want to be as detailed as possible here to get an accurate number.
Let’s say your total debt payments including a mortgage equals $2,000 per month. If your income is $6,000 a month, then your debt-to-income ratio is 33%. That’s because $2,000 is 33% of $6,000.
If you pay child support, own another home, or pay alimony to a former spouse, these payments are also factored into your debt totals. If you receive additional income, it’s important to include this as well. This will help lower your ratio.
What Is a Good Debt-to-Income Ratio for a Mortgage?
While each lender will have a different debt-to-income ratio to qualify, most subscribe to the 43% rule. This means that your debt can’t exceed 43% of your income to qualify for a mortgage. Depending on the lender and the type of loan you’re applying for, you may still be eligible for a loan if your ratio is higher. In other cases, your ratio will need to be lower. Your other assets and your down payment may help you qualify for a mortgage with a higher debt-to-income ratio, for example.
The lower your debt-to-income ratio is, the better your chances are of qualifying for a mortgage. This could also help you get a lower interest rate and better loan terms. Before applying for a mortgage, it can be helpful to improve your ratio. The sooner you start putting a plan together to lower your debt, the faster your ratio will improve. If you qualify for a home with a higher debt-to-income ratio, you can always refinance at a later time when your ratio improves. By this time, you may have lowered your monthly debts, and your home may have more equity. This can all add up to savings in interest.
How Can You Improve Your Debt-to-Income Ratio?
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Improving your debt-to-income ratio can significantly improve your chances of getting a mortgage and a lower interest rate. This can add up to a lot of money saved over time. Thankfully, your debt-to-income ratio isn’t set in stone. You can do a few easy things to improve your ratio before you apply for a mortgage.
To start, take a hard look at all your monthly debt payments. Reducing your monthly debt will lower your minimum payments and your debt-to-income ratio. Start with your high-interest credit cards. Make a plan for paying these down. Even a little more than your minimum payment will help. You should also avoid using these cards if you can. The less you spend on them, the less debt you’ll have.
Next, take a look at the smaller debts you have. This refers to small student loans or credit card bills you have. It can really help you lower your debt-to-income ratio and boost your credit score if you can pay these off. This means fewer monthly debt payments and more money saved on interest each month. Make a plan to cut spending in other places to make this a reality. Anything extra you can spare will help reduce your debt and debt-to-income ratio. This will help you qualify for a mortgage, get a better interest rate, and get into the home you want.