When you apply for a mortgage, your lender will examine your overall financial health. They will obtain a credit report, ask for proof of income, and calculate your debt-to-income (DTI) ratio. Your DTI will become more important as Fannie and Freddie are adjusting interest rates based on your DTI.
If your DTI is too high, you will most likely not be eligible for a home loan. The good news is that you can take steps to lower your debt-to-income ratio — and once you know where to start, it’s a very straightforward process.
Whether you are in the early stages of searching for a home or just want to make sure that you are in good financial health, the practical tips in this guide will help you lower your DTI and improve your chances of qualifying for a loan.
What Is Debt-to-Income Ratio?
What is debt-to-income ratio, and why does it matter when you apply for a mortgage?
Your debt-to-income ratio is the amount of monthly recurring debt payments compared to your gross monthly income. For instance, let’s say that your gross monthly income is $5,000. You have a total of $2,000 of recurring debt obligations, which include a car loan, rent, and a credit card balance.
To calculate your DTI ratio, you can divide your minimum payment and debts ($2,000) by your gross monthly income ($5,000). In this scenario, the result would be 0.40, or 40%. Generally speaking, you want your DTI to be 50% or less because this provides enough financial leeway to cover other expenses.
Not all of your monthly expenses are used to calculate DTI. When assessing your debt-to-income ratio, lenders will only examine certain bills and obligations.
These include rent or mortgage payments, car loans, student loans, credit card debts, or other monthly debt payments. They also include recurring obligations like child support and alimony. Your DTI does not include miscellaneous expenses like utility bills, home repairs, groceries, daycare, commuting expenses, health care/insurance, or car insurance.
DTI can be divided into two subtypes: front-end and back-end debt-to-income ratio.
Front-End Debt-to-Income Ratio
Front-end DTI is the ratio between your gross income and your current or projected housing expenses. This figure will include your base mortgage payment, property taxes, mortgage insurance, homeowners insurance, and homeowners association dues when applicable.
When evaluating your creditworthiness, lenders will assess your total DTI and your front-end DTI. Generally, lenders want your front-end DTI to be under 35%. However, some loan programs and lenders have slightly different thresholds.
Back-End Debt-to-Income Ratio
Back-end DTI is generally larger than front-end DTI. This figure represents the total recurring debts that you owe compared to your gross monthly income. The back-end DTI includes the front-end expenses (mortgage payment, property taxes, mortgage insurance, homeowners insurance, and homeowners association dues) and the recurring obligations we spoke of previously (car loans, student loans, credit card debt, child support, and alimony)
Breaking down DTI into front-end and back-end can help you better understand which financial obligations are making the biggest impact on your creditworthiness.
Ways to Lower Your DTI
If you’ll be applying for a mortgage soon and want to know how to lower debt-to-income ratio, remember these tips:
Pay Down Debt
Paying down debt is the most straightforward way to reduce your DTI. The fewer debts you owe, the lower your debt-to-income ratio will be.
However, keep in mind that your DTI will not immediately decrease when you begin lowering your overall debt.
Suppose that you have a car loan with a monthly payment of $500. You can begin paying an extra $250 toward the principal each month to pay off the vehicle sooner. This extra cash will reduce your overall debt faster and save you money in interest.
However, your DTI will not drop until your car loan is paid in full. DTI does not take into account the total amount of debt you owe; instead, it analyzes your monthly expenses in relation to your gross monthly income.
Debt consolidation is the process of combining multiple monthly bills into a single payment. You can consolidate debt by obtaining a personal loan and using those funds to pay off multiple loan payments, such as smaller loans and credit cards.
The monthly payment of your debt consolidation loan will be lower than the cumulative amount of all of your old payments. Therefore, it will drop your DTI.
Lower Your Interest on Debt
When a lender pulls your credit report, the report will outline how much you owe. It will also detail your monthly payments on each of your outstanding debts. Therefore, you can lower DTI by decreasing your monthly payment amounts, even if you do not reduce your total amount owed.
The easiest way to reduce your monthly payments is to refinance existing loans to lower your interest rate. Dropping the interest rate by just one or two percentage points can make a huge difference in your monthly payment, especially if the overall loan value is high.
When using this method, consider refinancing car loans and consolidating credit cards into a single personal loan. These efforts can make you more qualified for a mortgage by lowering your DTI.
Increase Your Income
Remember, your debt-to-income ratio is the amount of recurring monthly debt that you have compared to your income. You can reduce your DTI by lowering monthly debt payments — or by increasing your income.
The latter approach is a great option if you are close to the DTI ratio you need to be at in order to obtain a loan but need a little boost to get there.
If you want to boost your gross monthly income, consider getting a side hustle. You could deliver food, offer ride-sharing services, or make and sell crafts online.
You will need to generate a consistent amount of income using your side hustle for 2 years before lenders recognize this additional revenue stream. Therefore, you should work on increasing your income soon so that you will be able to obtain the loan you need when you are ready to buy a home.
Perhaps you are scheduled for a raise or promotion that will generate additional income. Or it may be time to consider a higher paying position or company.
How to Calculate Your Debt-to-Income Ratio for a Mortgage
Calculating debt-to-income ratio for a mortgage is quite simple as long as you know what debts show on your credit report. The chances are that you do since you have to pay these recurring bills each month.
When you want to estimate your DTI, start by listing your relevant monthly expenses, such as rent, credit card bills, and car loans. Remember, do not include the cost of groceries, gas, utilities, childcare, commute, or health care/insurance.
Next, determine your gross monthly income. You can do this in one of several ways. One way is to divide your annual gross income by 12. Alternatively, you can review four weeks of your most recent pay stubs.
Finally, divide your monthly debt payments by your gross monthly income. This calculation should yield a number between zero and one — for example, 0.40. This number is your DTI. It can be expressed as a percentage if you multiply it by 100. In this example, your DTI would be 40%.
If you have questions on this, please reach out! I can help by going over your situation and giving you suggestions that may help you when you are ready to buy a home!