For most people, buying a home is the largest financial decision they'll ever make. Because homes are so expensive, the vast majority of homebuyers need to take out a mortgage to finance the purchase. But getting approved for a mortgage isn't always easy, and one of the most important factors lenders consider when deciding whether to approve a borrower for a mortgage is their debt-to-income (DTI) ratio.
What is Debt-to-Income Ratio?
Debt-to-income ratio is a financial metric that compares a borrower's total monthly debt payments to their monthly gross income. The DTI ratio is expressed as a percentage, and a higher DTI ratio indicates that a borrower has more debt relative to their income. For example, if a borrower has $2,000 in monthly debt payments and $5,000 in monthly gross income, their DTI ratio is 40% ($2,000 / $5,000).
Lenders use DTI ratios to evaluate a borrower's ability to manage their debt and make their monthly mortgage payments. Generally, lenders prefer borrowers with lower DTI ratios because they are viewed as less risky.
How Lenders Use DTI Ratios to Qualify Homebuyers
When evaluating a mortgage application, lenders will typically calculate two different DTI ratios: the front-end ratio and the back-end ratio.
The front-end ratio compares a borrower's total monthly housing costs (including mortgage principal and interest, property taxes, and insurance) to their monthly gross income. Generally, lenders prefer borrowers with front-end ratios of 28% or lower.
The back-end ratio compares a borrower's total monthly debt payments (including housing costs, credit card payments, car loans, and other debt obligations) to their monthly gross income. Generally, lenders prefer borrowers with back-end ratios of 36% or lower.
However, these ratios aren't set in stone, and different lenders may have different criteria for what they consider an acceptable DTI ratio. Some lenders may be more flexible with DTI ratios for borrowers with high credit scores or large down payments, while others may be more stringent.
In addition to evaluating a borrower's DTI ratios, lenders will also consider other factors like credit score, employment history, and savings when deciding whether to approve a borrower for a mortgage loan.
Tips for Improving Your DTI Ratio
If you're planning to apply for a mortgage loan, there are several steps you can take to improve your DTI ratio and increase your chances of being approved for a mortgage.
One option is to pay down your existing debts, such as credit card balances or car loans, before applying for a mortgage. You can also consider increasing your income by taking on a second job or negotiating a raise at your current job.
Another option is to reduce your housing costs by choosing a less expensive home or by making a larger down payment to reduce your monthly mortgage payment.
In conclusion, the debt-to-income ratio is an important metric that mortgage lenders use to evaluate a borrower's ability to make their monthly mortgage payments. By understanding how DTI ratios work and taking steps to improve your own DTI ratio, you can increase your chances of being approved for a mortgage and achieving your dream of homeownership.