When you apply for a mortgage, auto loan, or credit card, the lender will add up your monthly payments and then include the proposed new payment in the calculation. Your before-and-after debt-to-income ratios (DTIs) determine your eligibility for a loan and the amount you may qualify for. So, how much does your debt-to-income ratio influence your ability to get a mortgage? Let’s find out.
What Is Debt-to-Income (DTI) Ratio?
The debt-to-income (DTI) ratio is the percentage of your monthly gross income that goes to paying your monthly debt payments. Lenders use this to determine your borrowing risk. A lender will look at both your Gross Debt Services (GDS) and your Total Debt Services (TDS) ratios:
- Your Gross Debt Service is the percentage of your income requirement to pay all of your monthly housing costs, including utilities and condo fees. For example, if your monthly income is $10,000 and your monthly housing costs are $4,000, your GDS is 40%.
- Your Total Debt Services ratio is the percentage of your income towards housing, plus your monthly commitment to debt payments on loans, credit cards, and vehicle payments. For example, if you have a monthly income of $10,000 and housing costs of $4,000, plus debt payments of $750, your TDS is 47.5%.
Therefore:
GDS = Principle + Interest + Taxes + Heat + 50% condo fees / gross income
TDS = (Principle + Interest + Taxes + Heat + + 50% condo fees + debt payments)/ gross income
A high DTI tells lenders that your budget can’t accommodate another loan payment, as you’re close to overextending. Conversely, a low DTI signals you have plenty of breathing room and handle credit responsibly.
Understanding Debt-to-Income (DTI) Ratio
A low debt-to-income (DTI) ratio demonstrates a good balance between debt and income. In other words, if your DTI ratio is 15%, this means that 15% of your monthly gross income goes to debt payments each month. Conversely, a high DTI ratio can signal that an individual has too much debt for the amount of income coming in each month.
Typically, borrowers with low debt-to-income ratios are likely to manage their monthly debt payments effectively. As a result, banks and financial credit providers want to see low DTI ratios before issuing loans to a potential borrower. The preference for low DTI ratios makes sense since lenders want to be sure a borrower isn’t overextending, meaning they have too many debt payments relative to their income.
As a general guideline, 43% is the highest DTI ratio that a borrower can have and still qualify for a mortgage. Ideally, lenders prefer a DTI ratio lower than 36% with no more than 28% to 35% of that debt going toward servicing a mortgage payment.
What is a good debt-to-income(DTI) ratio?
In general, the lower the DTI you have, the better:
- 35% or less: Ideal for any type of borrowing. Your debt is manageable – qualifying for credit is easier
- Between 36% and 43%: Debt is manageable, but less money left after covering bills and minimum debt payments.
- Between 43% and 50%: You may be able to qualify for some loans, but lenders are usually more stringent with their requirements. You’ll typically need excellent credit (or a creditworthy co-applicant) and a high income to qualify for a loan.
- Above 50%: With more than half of your gross income going toward debt, you’re unlikely to qualify for loans or lines of credit. If you do, you’ll face higher interest rates.
What Are the Limitations of Debt-to-Income Ratio?
One of the limitations of a DTI ratio is that it does not distinguish between different types of debt and the cost of servicing that debt. For example, credit cards carry higher interest rates than student loans. However, they’re lumped together in the DTI ratio calculation. If you transfer your balances from your high-interest-rate cards to a low-interest credit card, your monthly payments will decrease. As a result, your total monthly debt payments and your DTI ratio will decrease. However, you will see that your total debt outstanding will remain unchanged.
The maximum DTI ratio varies from lender to lender. However, the lower the debt-to-income ratio, the better the chances that the borrower will be approved, or at least considered, for the credit application.
How Does Your Home Insurance Affect Your DTI?
“Property taxes and homeowners insurance are part of the debt-to-income ratio calculation,” says Denise Panza, a senior mortgage banker with Total Mortgage. “They are a huge piece of the equation.” Taxes and insurance are typically paid along with your mortgage principal and interest. As such, lenders will add the monthly cost of taxes and insurance onto your mortgage payment to determine what you can afford. If you plan to purchase a home, you should consider how much your property taxes and homeowners insurance will cost. Additionally, you will need to factor in how both will affect your overall home-buying budget. Since the cost of property taxes and insurance varies from one homeowner to the next, some buyers will be impacted more than others.
Reducing Your Debt
When you take on a mortgage, you are essentially taking on long-term debt. This means you will most likely want to minimize any existing debt you may have. Credit card debt, student loans, and other forms of debt can get in the way of you making your mortgage payments. It is always best to get them out of the way so that you can focus on paying off your mortgage for the time being. As mentioned above, having outstanding debt can also make it more difficult for you to be approved for a mortgage in the first place. This is due to lenders looking at your debt-to-income ratio when considering if you are reliable to lend to.
Lowering Your Debt-to-Income Ratio
Reducing your DTI can help you qualify for the best loan options. Additionally, it also ensures you have some cushion in your budget. To lower your DTI, consider these tips:
- Pay off debt: When you repay a debt owed in full, that monthly payment no longer factors into your DTI. With one less payment, your DTI will decrease. You might first consider repaying debts with the lowest balances (also known as the debt snowball method) to remove that payment from your DTI.
- Repay high-interest debt first: If you’re focused on your long-term financial health, following the debt avalanche method — where you pay down the debt with the highest interest rate first — can help you save money on interest. Eliminating debt will lower your DTI.
As a general rule of thumb, lenders want to see a GDS of 32% or lower, and a TDS of 40% or lower.
- Increase your income: It’s easier said than done, but asking for a raise, getting another job, or launching a side hustle can boost your income. With more income, your ratio will drop.
- Avoid new debt: If you increase your credit card balance with new purchases or apply for a new form of credit, your DTI will go up.
- Refinance debt: If you qualify for better rates than you currently pay, your monthly payment may be lower, improving your DTI. You could also lower your monthly payment by extending the loan term. However, this comes at the cost of higher total interest.
DTIs: The Bottom Line
Debt-to-income (DTI) ratio is the percentage of your monthly gross income (your pay before taxes and other deductions are taken out) that goes to paying your monthly debt payments. Lenders use your DTI ratio to determine your borrowing risk. To better your chances at securing a loan, be sure to look into refinancing your debt and paying down whatever debt you can afford.
To help your DTI score, remember you can speak with one of our isure representatives at options to reduce your overall insurance payments. Bundling insurance, increasing your deductibles or even examining coverages to better tailor them to you. Immediate needs can help to lower your monthly payments. Small changes like these can make a big difference in the type of loan you can qualify for.
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