Fundamentally, your debt to income ratio (DTI) is the percentage of your income that is used to pay your debts, and is often abbreviated to the ‘debt ratio.’ Your ‘income‘ is your total gross income from all sources before tax, and the ‘debts‘ cover everything that you are currently repaying.
For example, let’s say you earn $4,200 each month and also have an investment income averaging $300 each month. Your income is then $4,500 monthly. Let’s also say that your mortgage is $870/month, your home insurance and property taxes come to $200, your credit card payments average $300 and you have an auto loan of $250 each month. Your total monthly debt is $1,620, so your income to debt ratio would be calculated as:
100 x 1620/4500 = 36%
This means that 36% of your total gross income is used to repay your debts.
Presentation of Debt Ratios
In the USA and some other countries it is common, but not essential, to present debt to income ratios using two figures, known as the ‘front-end’ and back-end’ ratios. While the above 36% is useful to lenders, it is even more useful to separate the payments made to the individual’s current home costs from their other debts. To make this clearer, let’s consider another set of figures.
The front-end ratio relates to the income spent on housing costs, including the mortgage repayments, rental payments, housing taxes, home insurance, mortgage insurance and so on. In the simplified example provided, this sum totals $1,070 each month. The rest of the 36% involve costs not associate with your home ownership or rental.
Taking this figure and calculating the debt to income ratio for that, it comes to 100×1070/4500 = 24% (to nearest whole figure). The DTI here would then be expressed as 24/36. The lender now knows that 24% of the 36% DTI is related to your home, and only 12% to other debts. This is important because it gives the lender an idea of your debts unconnected to your home ownership or rental.
Speaking generally as diffferent lenders vary, one lender might insist on a figure of at least 28/36, so that the above person would not qualify. With a DTI lower on the front end, it means that there are more debts other than for housing. This would have a negative effect on your likelihood of being offered a loan or another mortgage.
How to Improve your Debt to Income Ratio
It is important that you start by getting an accurate indication of your current DTI. Then you should work on paying less each month on your non-housing related debts. Reduce your credit card payments, pay off your auto loan(s) and try to clear as many other debts as you can, or at least negotiate reduced monthly payments.
It is not your total debts that lenders are concerned about, but with how much income you have available after paying the monthly repayments for your non-housing related debts. They want to get a feel for whether or not you can afford the added burden of a monthly mortgage payment. They know the rough cost of living in your area, and will apply a debt to income ratio appropriate to what they believe you will have left after paying your other debts plus your living expenses.
Where Is Your Debt to Income Ratio?
For a FREE rate quote and an evaluation of your current debt to income ratio and ability to qualify for a new home purchase or refinance, please call us at the number above. We can also help you understand what loan programs are available and which ones makes the most sense for your needs.