Debt-to-Income Ratio: What Homebuyers Need to Know
The NFCC often receives questions from readers about their money challenges. We answer common questions in our Ask an Expert series to help readers find the information they need.
Question: I’m considering buying my first home. I’ve been doing some research and keep hearing about the debt-to-income ratio. What exactly is the debt-to-income ratio and how does it affect my mortgage application?
Answer: Dear Reader,
There are many factors that lenders consider when deciding if you qualify for a mortgage, and your debt-to-income ratio (DTI) is one of them. This ratio specifically looks at how much of your income goes toward covering your minimum required debt payments each month.
If your DTI is too high, you could have trouble getting pre-approved for a mortgage. That’s because a high DTI signals to lenders that you may have trouble repaying your debt as a homeowner, and you could even end up missing mortgage payments or going into foreclosure.
Here’s a breakdown of the basic information you need about DTI as an aspiring homeowner.
Front-end versus back-end debt-to-income ratios
There are two types of debt-to-income ratios that lenders look at. Here’s a look at each one:
- Front-end-ratio: Compares your gross (pre-tax) income to your potential mortgage payment, including interest, property taxes, insurance and homeowner association fees.
Formula: (Housing payment / monthly income) x 100 = Front-end DTI
- Back-end-ratio: Compares your gross income to all of your minimum monthly debt payments, including the potential mortgage payment.
Formula: (Total minimum monthly debt payments / monthly income) x 100 = Back-end DTI
So let’s say you earn $70,000 a year ($5,833 a month) and your potential mortgage payment is $2,000. To calculate your front-end DTI, you would divide $2,000 by $5,833 and then multiply the result by 100. In this case, your front-end DTI would be 34%.
What is a good debt-to-income ratio for a mortgage?
Each lender has their own debt-to-income ratio requirements. However, most mortgage lenders are looking for a maximum front-end DTI of 28% to 31% and a maximum back-end DTI of 36% to 43%.
If you’re looking for more flexibility, you might consider special loan programs that have higher DTI caps. For example, FHA loans allow DTIs up to 50% and VA loans do not have an official cap.
How can you reduce your debt-to-income ratio?
There are several different ways to reduce your debt-to-income ratio, although some are easier than others. Here are some of the ways to bring your DTI figures down:
- Pay off one or more of your debts to eliminate a debt payment.
- Increase your income.
- Apply for a smaller loan.
- Make a larger down payment.
Keep in mind that paying off debt can potentially mean having less money for your down payment. If you’re not sure whether your money would be best used to reduce debt or increase your down payment, ask your lender for guidance.
Preparing for your mortgage
DTI ratios help lenders determine if you can afford a mortgage. However, you should not use them to determine how much mortgage you can truly afford. That’s because DTI does not consider many of your major expenses, such as food, utilities, daycare, healthcare and more.
For that reason, I recommend having a solid budget in place to help you determine what payment amount you can really afford. You can also schedule a session with an NFCC-certified credit counselor to review your credit, your budget and your debt, to help you best prepare for this big milestone.
Best of luck!
Sincerely,
