Your debt-to-income (DTI) ratio is the percentage of your income that goes toward paying your monthly debts. DTI can often be overlooked as many people assume that a good credit score and a high income are the only two factors needed to be taken into consideration when seeking to purchase a home.
However, for many lenders, that’s not enough to be considered a good mortgage candidate. As a borrower, your DTI is utilized in various situations to determine your level of risk. For instance, if your DTI is too high, opportunities to make a big purchase, such as a mortgage, may be limited.
How to Calculate Your DTI Ratio
DTI Ratio = (Monthly expenses ÷ Pre-Tax Income) x 100
Start by adding up your monthly bills such as:
- Rent or house payment
- Alimony or child support
- Student loans
- Auto payments
Next, divide your total sum by your gross monthly income (income before taxes). Multiply by 100. Your result is your DTI ratio.
The goal is to keep your DTI ratio as low as possible. The lower the ratio, the less risky you are to lenders. An adequate DTI ratio is below 36 percent. Typically, having a DTI ratio of 43 percent is the maximum ratio you can have in order to be qualified for a mortgage.
Front-End DTI vs. Back-End DTI
There are two variations of DTI: Front-End and Back-End.
A front-end DTI calculates how much of a person’s gross income is going towards housing costs.
Front-End DTI = (Housing Expenses ÷ Gross Monthly Income) x 100
A back-end DTI calculates the percentage of gross income going toward other types of debt (credit cards, car loans, etc.).
Back-End DTI = (Total monthly debt expense ÷ Gross Monthly Income) x 100
The main difference between Front-End and Back-End DTI ratios is that the front-end ratio only considers the mortgage payment and other housing expenses whereas the back-end ratio considers all other types of debt. Lenders will utilize this ratio in conjunction with the front-end ratio to approve mortgages.
Why is Knowing Your DTI Ratio Important?
Your DTI ratio is utilized by lenders as a measuring tool. Your DTI ratio helps lenders determine your ability to manage your finances, specifically, your monthly payments to repay the money you borrowed. Keep in mind that lenders do not know what you will do with your money in the future, so they refer to historical data to verify your income and debt totals. Moreover, your DTI ratio illustrates that you have a sufficient balance between your income and debt, thus, are more likely to be able to manage your mortgage payments.
If you are considering buying a home or have questions about your DTI ratio, give us a call!
This blog post was written by experts at Mortgage 1 and originally appeared on www.mortgageone.com. Michigan Mortgage is a DBA of Mortgage 1.