Are you planning to buy a house soon? If you do, then knowing your debt to income ratio is as important as knowing your credit score and your credit history because it plays a vital role and can come in the way of you being able to qualify for a mortgage in the first place.
A debt-to-income ratio (DTI), simply put, is the percentage of your gross monthly income that goes towards paying your fixed expenses such as taxes, fees, insurance premiums, and debts. It helps lenders to determine your ability to buy a home and whether your finances are good enough to take on a mortgage. If your DTI is too high than mortgagers will not be willing to lend you money or will charge you a much higher interest rate for your mortgage loan.
Understanding Debt to Income Ratio
There are two primary types of debt to income ratios that most mortgagers consider when you apply for a mortgage. The two ratios are:
Front-End DTI Ratio
The front-end ratio, which is also called the housing ratio, is the amount of your monthly income that will go for your housing costs. It includes your monthly mortgage payment, property taxes, homeowner’s insurance, and any homeowner’s association dues. Your total value of housing costs will be divided by your income to get the front-end ratio.
Front-End DTI = (Housing Costs ÷ Gross Monthly Income) x 100
Back-End DTI Ratio
The back-end ratio is the percentage of your gross monthly income that pays for your housing costs along with all other monthly debt obligations. It includes credit card payments, car loans, student loans, child support, and other fixed expenses.
Back-End DTI = (Total monthly debt expense ÷ Gross Monthly Income) x 100.
For example, if you pay $300 on credit cards, $200 on car loans $1500 on your mortgage than your total monthly debt is $2,000. If your gross yearly income is $48,000 then your monthly income will be 48,000 divided by 12 or $ 4000. So your debt to income ratio is $2,000 ÷ 4,000 which will work out to 0.5 or 50 percent.
Remember that homeownership comes with many other expenses like homeowners’ association fees, property tax, repairs, and routine repairs. These are not considered debts and therefore they are not taken into consideration when calculating your DT ratio. The other basic expenses that are not included is your non-debt expenses like utilities, transport or food.
Lenders generally utilize the back-end ratio in conjunction with the front-end ratio to approve of a mortgage. However, the back-end ratio is more important as it gives a bigger picture of your finances.
If you have no other debt and your housing costs are relatively high, mortgagers will be willing to lend you money as your total financial indebtedness will be manageable.
What is a Good Debt-to-Income Ratio for Mortgages?
An ideal front-end debt-to-income ratio is 28% and the back-end ratio is 36%. However, in most cases, lenders will allow a back-end ratio of 43 percent. It is the highest ratio that you can have if you want to qualify for a mortgage. But, if you can get a loan through a government backing program like an FHA loan or have a savings account with a balance of six months of housing expenses your back-end ratio can be as high as 50 percent.
If your Debt-to-income ratio is 50% or higher, your borrowing options will be limited and you do not have a good chance to qualify for low mortgage rates.
What Should You Do to Lower Your Debt-to-Income Ratio?
There are two key methods to reduce your DTI ratio: one is reducing your debt and the other increasing your income. Here are some tips to reduce your DTI ratio.
- Avoid taking on any new loans or lines of credit.
- Take up some freelance work or a part-time job.
- Lower your credit card balance by making extra payments.
- Look into your budget and try to reduce your day-to-day expenses so that you can pay off as much as possible on your current debt like your student loan or auto loan.
- Avoid making any big purchases on credit that are not necessary.
- Asking for a pay raise at work to boost your income. However, it may not be possible to get one quickly.
Calculating your DTI is not a difficult task, now is it? Once you figure out this crucial number you can do a little planning to improve it before you apply for a mortgage. It will ensure you get the best rates and the lowest payments.
If you are planning to buy a home or have any queries about your DTI ratio, feel free to call us at (877) 877 7575