Buying a house is expensive, but having a good debt-to-income ratio can keep costs down by giving you access to the best mortgage interest rates.
Your DTI ratio helps lenders decide how much risk you pose as a borrower. A high ratio could signal high risk to the lender and equate to high interest for the borrower.
Find out more about how a DTI ratio is calculated and which ratios are most likely to help you get the mortgage you desire.
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How Is Debt-to-Income Ratio Calculated?
Calculating your DTI ratio is simple: Total your monthly bills and divide that number by your gross monthly income, or your pay before taxes or other deductions.
Let's say you spend $1,200 on rent, $500 on a credit card bill and $150 on an auto loan, or $1,850 total on monthly debt payments. Your gross monthly income is $5,000. Divide your monthly debts ($1,850) by your gross monthly income ($5,000), and the result is a DTI ratio of 0.37, or 37%.
Front- vs. Back-End DTI Ratios
Two types of DTI ratios are important to secure a mortgage:
Front-end DTI ratio. This ratio strictly focuses on how much of your gross income is earmarked for housing costs. You can calculate it by adding up your monthly housing expenses, such as mortgage and insurance payments, dividing the total by your gross monthly income and multiplying the result by 100.
If your housing-related expenses are $1,000 and your gross monthly income is $3,000, your front-end DTI would be 33% ($1,000/$3,000=0.33; 0.33x100=33.33%).
The front-end ratio best indicates how much income the borrower puts toward the mortgage, "which greatly impacts their ability to repay" on time, says Jamie Cavanaugh, chief operating officer of Amerifund Home Loans, Simi Valley, California.
Back-end debt-to-income ratio. This ratio represents how much of your gross monthly income is earmarked for paying debts, including credit cards, car loans and housing payments. Total your monthly debts, divide the sum by your gross monthly income and then multiply the result by 100 for your back-end DTI ratio.
Lenders weigh front- and back-end ratios when deciding whether to approve a loan. "Even if a borrower's front-end housing ratio is low, their total debt-to-income ratio may be so high that they would have difficulty managing their new mortgage payment," Cavanaugh says.
The back-end ratio is more important than the front-end ratio on your loan application, says Brendan McKay, owner and senior loan officer at McKay Mortgage Co., Bethesda, Maryland.
"The majority of programs put little emphasis on front-end DTI, and to some degree, it makes sense," McKay says. "Someone's budget is their budget. Whether a dollar of that budget is going toward a mortgage or a car payment, their bank account feels it exactly the same."
Why Is Debt-to-Income Ratio Important?
Having a strong DTI ratio is essential to qualifying for a home loan with the best terms. Studies have showed that people who have higher DTI ratios are more likely to struggle with payments, according to the Consumer Financial Protection Bureau.
If your DTI ratio climbs above 43%, the CFPB says, you may not be able to get a qualified mortgage. A qualified mortgage meets certain guidelines put in place to prevent lenders from issuing loans that borrowers can't afford to repay.
How Does Debt-to-Income Ratio Relate to My Credit Score?
Your DTI ratio has no effect on your credit score or your credit report. Yes, someone carrying a lot of debt might have a high DTI ratio and a poor credit score, but the two have no direct relationship, according to the credit bureau Equifax.
Credit scoring models often consider a different ratio -- your credit utilization ratio -- when calculating your credit score.
Of course, a strong credit score is a crucial part of qualifying for a mortgage at the best rate possible. A reputable credit repair company can help if you are struggling to get your credit score ready to buy a home, Cavanaugh says.
How Can I Improve My Debt-to-Income Ratio?
You can try two ways to improve your DTI ratio, although they are deceptively simple: "Make more money, or pay off debt," McKay says.
If you hope to achieve both, Equifax suggests asking yourself these questions:
-- Can you pay off an auto loan or a credit card?
-- Can you get a debt consolidation loan to lower your monthly credit card payments?
-- Have you omitted income from your loan application, such as money from a side business or second job? Extra cash improves your ability to pay back a mortgage.
-- Can you negotiate a raise or work overtime? You may want to pause your loan application if a raise is coming.
Before paying off debts, talk to your "https: loans.usnews.com articles should-i-work-with-a-mortgage-broker">mortgage broker