You have found your dream house. Everything looks amazing. In fact, it seems this house was made for you. 

Now, all that's left is to get a mortgage. And you feel confident because you have a good credit score, a solid income, and you have been servicing your debts. 

Then the lender tells you that your debt-to-Income (DTI) ratio is too low and they can't approve your loan. What gives? 

In this article, we will define what DTI ratio is and how it affects your mortgage application. We will also provide examples to help you understand how to calculate your DTI ratio and tips to improve it.

TLDR Key Takeaways

• Debt-to-income ratio shows what percentage of your overall income goes toward paying off loans and other obligations such as credit cards, student loans, and car payments.
•  Most mortgage lenders will not approve a borrower with a DTI over 43%.
• Borrowers with low DTI ratios are more attractive because they have sufficient income to cover debt servicing.

What is Debt-to-Income (DTI) Ratio?

Debt-to-income ratio (DTI) is a personal financial metric used to determine how much of an individual's income is available for debt payments. 

When applying for loans and other types of credit, lenders may use an individual's DTI ratio to determine if they are suitable borrowers with enough disposable income to pay off the loan installments in time. 

The lender usually sets a maximum allowable DTI before approving a loan application. So, having a low DTI provides more opportunities for getting approved for loans with favorable terms and interest rates.

There are two types of DTI:

• Front-end DTI: The front-end debt-to-income (DTI) ratio, or the housing ratio, measures how much you spend on housing. It is usually calculated by dividing housing expenses (like mortgage payments and insurance) by gross income.
• Back-end DTI: Your back-end DTI includes your front-end DTI plus all other debts you pay monthly, like student loans, personal loans, car loans, and credit cards. So the back-end DTI is usually higher since it takes into account all the debts. 

Most mortgage lenders will focus on your back-end DTI for loans that aren't government-sponsored because it gives them a more holistic picture of your financial situation. 

How DTI Affects Your Mortgage

Lenders consider your DTI when deciding whether to approve your mortgage application. This is because a DTI ratio says a lot about a person's ability to manage debt.

A low debt-to-income ratio shows that you manage your finances well and stay on top of your debts while a high debt-to-income ratio indicates the opposite. 

Lenders must apply some level of rationality before approving anyone for a mortgage, especially when that person has high debts.

If you have a low DTI ratio, for example, 15%, your chances of securing a home loan are higher. And in most cases, a high DTI, like 50% or more, means you will not qualify for a mortgage or get a reduced loan.

How to Calculate Your Debt-to-income Ratio?

Use the formula below to find your DTI ratio:

DTI = Monthly Payments ÷ Gross Monthly Income x 100

Let’s break it down:

1. Add Up Your Minimum Monthly Payments 

Focus on your credit score-reported debts as a monthly expense. Examples include credit card payments, student loans, auto, and personal loans. 

Use your minimum monthly payment for these calculations - not your account balance or typical monthly payment. For instance, if your required credit card payment every month is $200, that's your minimum due each month. Include only the minimum of $200, even if you contribute $400 or more.

2. Divide Your Monthly Payment By Your Gross Income

Your gross monthly income includes all your earnings monthly before taxes and other deductions. You can include your salary and other income, such as interest and dividends. 

Next, divide your total monthly payment by your gross monthly income once you've determined your gross monthly income.

3. Convert the Result to a Percentage

The result will be a decimal value. Multiply that by 100 to determine your DTI ratio.

Example

Let's assume your gross monthly income is $5,000, and your monthly expenses include a student loan of $400, a car loan of $400, and a personal loan of $200.

Your monthly expense is $400 + $400 + $200 = $1,000

$1,000 ÷ $5,000 X 100 = 20

So, your DTI ratio is 20%.

What Is a Good Debt-to-Income Ratio?

A DTI ratio of 35% or less means your debt is manageable, and your mortgage application has a high chance of approval. 

A 36%-49% DTI indicates that although you manage your debt adequately, there is room for improvement. 

And borrowers with DTIs of 50% or more must focus on reducing their debts before applying for a home loan.

But in general, lenders typically require a DTI ratio of 43% or lower., meaning you should only be paying at most 43% of your gross monthly income toward your debts—including your new mortgage.

The new mortgage payment should take up no more than 28% of that 43%. 

Regardless, it is always a good idea to reduce your debt as much as possible.

Quick Tips to Improve Your Debt-to-Income Ratio

Lower Your Interest Rates on Debts

Interest rates can increase your monthly payments. So consider refinancing some of your debts or transferring credit balances to lower their interest rates. Negotiate directly with your creditors to reduce your interest rate.

Raise Your Income

You can lower your DTI by starting a side hustle, picking up more hours at your current job, or freelancing. The only requirement is that you prove that your income is regular and sustainable. Most lenders prefer to see a two-year history of each source of income.

Extend the Duration of Your Loan

Consider extending your loan term. You can reduce your monthly payments by extending the loan's term since you're spreading them out. A loan extension, however, often comes with a higher interest rate as a trade-off.

Let Money Day Lending Help You Get the Financing You Deserve

Your DTI is a crucial factor that lenders consider when deciding to approve your application for a mortgage.

However, other factors, like being a freelancer or entrepreneur, can count against you because you don't have a conventional income stream. That's where Money Day Lending can help. 

With our 20 years of experience, we help entrepreneurs, freelancers, and self-employed individuals get access to capital on good terms.

Want to learn more? Schedule a consultation with us to discuss your options today.