Your debt-to-income ratio (DTI) is among the most crucial considerations for a mortgage lender because it signifies your financial ability to pay off a mortgage loan. A high DTI tends to mean more risk for the bank, a smaller DTI means less risk.
What is a Debt-to-Income Ratio?
Your debt-to-income ratio is essentially the percent of your monthly gross income that services debts (car loans, bank cards, lines of credit, etc.) as well as housing expenses (mortgage payments, including property taxes and insurance, HOA fees, rent payments, etc.).
If your DTI is high, it means you have very little additional cash to manage unexpected bills while keeping up with your home loan payments, which represents increased risk for the lender. By comparison, if your DTI is low, you have adequate additional cash flow on a monthly basis to easily make your payments and cover unplanned expenses.
The maximum debt-to-income ratio permitted right now is 50% for FHA mortgages and 45% for conventional mortgages. Put another way, for a conventional loan, a maximum of 45% of your monthly qualifying income can be used on debt service and home expenses, 50% for FHA-insured loans. The policies for FHA and conventional mortgages do sometimes allow for higher DTIs, but only on a limited basis and with compensating factors including high credit ratings, assets, low loan-to-value, etc.
When you are working with your mortgage lender, you might hear the lingo “front end” and “back end” DTI come up. Your “front end” DTI is the proportion of your wages that pays just your house payment, including property taxes, homeowners insurance, mortgage insurance, as well as HOA fees. “Back end” DTI includes all housing and debt expenses.
Today, front end DTI is not as major a consideration as it was previously, but it still does come up occasionally. Most lenders today are concerned primarily with your back end DTI.
To calculate DTI, simply divide your overall monthly financial debt payments as well as rent or housing payments (including taxes, insurance, mortgage insurance, and HOA fees) by your gross monthly income, as follows:
1) Get a copy of your credit report or gather up your most recent statements for all your debt obligations. Be aware that only debt obligations are a part of your DTI, not electric bills, phone, cable tv, etc.
2) Total up all payments for all debts except for your rent or mortgage for the moment. Make sure to include car loans, credit cards (use just the minimum payment), lines of credit, college loans, and any other debt obligations that you have.
3) Now add to your running total your monthly rent payments or mortgage payment, including taxes, insurance, any mortgage insurance or PMI, and HOA fees.
4) Divide the sum by the gross monthly income, then multiply by 100 to obtain your DTI percentage.
If you plan to buy a house or refinance your current home mortgage and want to determine your DTI for the new home loan, substitute your current rent or house payment (including all taxes, insurance, mortgage insurance, and HOA expenses) for the new estimated house payment.
Get the scoop on another common mortgage acronym at What is APR?