Jean Chatzky
Do one thing: Before applying for a loan, use an online debt-to-income ratio calculator to figure out what your percentage would be if you took on the additional debt of a new mortgage. SavvyMoney users can also calculate their DTI through their online banking dashboard.
Understanding Your Debt-to-Income Ratio
You might not think about your debt-to-income ratio often. Maybe you’ve never even heard the term. But it’s an important stat to keep in mind, and it can have a big impact on your ability to qualify for a loan and the interest rate you may potentially be charged to borrow money.
What is Debt to Income?
In a nutshell, your debt-to-income ratio shows how much of your monthly income goes toward paying off debt. Knowing this number – and knowing all of the factors that go into it when applying for a mortgage – can help you make more confident financial decisions. It can also help you to understand what lenders see so you can:
- Time applications more strategically.
- Qualify for stronger offers.
- Make more informed decisions about taking on or paying down debt.
Calculating Your Debt-to-Income Ratio
To determine your DTI, divide your total monthly debt payments by your gross monthly income.
- Example. If your gross monthly income is $8,000 and your monthly debt payments total $2,000, you would divide 2,000 by 8,000 to get 0.25, or 25%. Your debt-to-income ratio would be 25%.
- Learn more about how lenders use debt-to-income to evaluate loan applications
What Debt is Included in Your Debt-to-Income Ratio?
Mortgage underwriters count anything on your credit report with a required minimum payment, notes Certified financial planner Jeff Judge, AEP, ChFC, CLU, managing partner with Chesapeake Financial Planners in Maryland. That generally includes:
- Car loans
- Student loans
- Credit card minimum payments
- Personal loans
- Child support
- Co-signed debt
What Lenders May Add to Your DTI
While your current rent doesn’t count toward your DTI once you’re buying a home, some other things do, Judge explains. Lenders generally include the amount of the new monthly mortgage payment in the calculation. That mortgage payment typically encompasses all of the following:
- Principal
- Interest
- Taxes
- Homeowners insurance
- Private mortgage insurance (PMI)
- Any Homeowner’s Association dues
Common DTI Misunderstandings
Mortgage DTI rules are often stricter and more specific than general debt-to-income guidance. In fact, Judge says many people calculate their own DTI incorrectly before talking to a lender. “They forget the lender counts the new mortgage payment, including taxes and insurance, not just their current bills,” Judge says. “I’ve seen buyers get pre-approval shock because they never included property taxes and homeowners insurance in their own math.”
How Lenders Evaluate Your Income
A discussion about how financial institutions evaluate your finances when applying for a loan wouldn’t be complete without explaining how they determine an applicant’s earnings.
On the income side, Judge says, lenders want to see gross income that’s stable and likely to continue. While those with W-2 wages have a pretty straightforward path, those who are self-employed have their earnings handled a little differently. For the self-employed:
- Income usually gets averaged over two years of tax returns.
- Bonus and commission income generally need a two-year history as well.
- Rental income counts, but often at a reduced percentage for vacancy and expenses.
DTI Ratio Numbers to Know
- 36% – The maximum total debt-to-income ratio for those seeking home loans is often 36%, according to Fannie Mae, but that percentage can go up to 45% (or more) with strong credit and reserves.
- 43% – While there is no universal debt-to-income ratio limit for lenders, 43% is often used as a benchmark for mortgages under the Qualified Mortgage rule, according to the U.S. Government Accountability Office.
- 50% – Some online lenders allow a debt-to-income ratio of up to 50% for those seeking home loans. It’s often considered an upper limit in certain cases.
Key Facts About Your DTI
- It’s not just for mortgages. Lenders also look at your DTI when you apply for auto loans, personal credit lines, or home equity loans.
- It’s part of a bigger picture. Your DTI is just one piece of the puzzle. Lenders combine it with other factors — including your credit score — to evaluate your overall financial health before granting new credit.
- Living costs don’t count. While lenders factor in your estimated monthly house payment, day-to-day expenses like utilities, health insurance, and groceries aren’t included.
Debt-to-Income Ratio Pitfalls to Avoid
While calculating your DTI before applying for a home loan may seem straightforward, there are often factors that people don’t take into account before meeting with a lender, explains Judge. Among them:
- Using cash flow as income instead of documented income tax returns.
“I tell clients never to assume a DTI rule of thumb applies to their specific loan type,” Judge says, “without confirming it with their lender directly.”
With reporting by Casandra Andrews
Chris O'Shea
