Today’s lenders value risk aversion almost as much as they value the interest generated from their loans. If for nothing else, there’s nothing more valuable to an institutional bank than a borrower who is likely to maintain their loan obligations; anything less would result in a loss of revenue. As a result, banks and lenders have developed a unique basket of tools to help determine how likely a borrower is to pay back their debts. Of the tools they trust their business operations to, however, one has separated itself from the pack: the debt-to-income (DTI) ratio.
The DTI meaning, as it relates to receiving mortgage approval, carries a lot of weight; it can determine whether or not a borrower receives approval for a loan. Perhaps even more importantly, however, prospective borrowers actually have more control over their DTI than they may realize. As a result, it’s not only important to know the DTI meaning, but also how to calculate debt-to-income ratios and lower it.
For more information on using the debt-to-income ratio to buy a house and how borrowers can improve their odds of receiving a loan, please refer to the following.
What Is Debt-To-Income Ratio?
The debt-to-income ratio is a metric which deduces a borrower’s ability to service debts based on their current monthly income. In its simplest form, the DTI meaning identifies exactly what percent of a person’s income is dedicated to monthly debt obligations. At its pinnacle, however, the debt-to-income ratio is a tool which enables institutional lenders to mitigate risk. If for nothing else, the ratio will tell lenders approximately how much money their borrowers will have after monthly debts are serviced. The larger the percentage, the more risk a borrower poses to the lender. Conversely, borrowers who dedicate a smaller percentage of their income to monthly debts are less of a risk.
How A Debt-To-Income Ratio Works
Debt-to-income ratios work a lot like a credit score; lenders will use them to determine the level of risk borrowers represent. That said, borrowers with lower debt-to-income ratios constitute less of a risk to lenders than those with higher ones. Borrowers with lower debt-to-income ratios, for example, pay less monthly income towards debts and are more likely to manage their money effectively. As a result, lenders view borrowers with lower debt-to-income ratios as less of a risk to default on a loan because they will most likely have enough money to keep up with monthly bill obligations. Those with higher debt-to-income ratios, on the other hand, are viewed as more of a default risk because a higher percentage of their income is already dedicated to monthly bills. With less disposable income, borrowers with a high debt-to-income ratio are more likely to default.
DTI Ratio Limitations
The debt-to-income ratio is ultimately a tool used by banks and lenders to determine a borrower’s ability to pay back debts. It is worth noting, however, that the debt-to-income ratio isn’t intended to be used as the sole metric for gauging a borrower’s creditworthiness. Instead, it’s important to acknowledge that the DTI ratio has its limitations. Due to its shortcomings, the debt-to-income ratio should be viewed as a compliment to other metrics like credit scores.
Most notably, the debt-to-income ratio neglects to differentiate between different types of debt and their respective service costs. At the very least, not all debt is created equal. Credit cards, for example, have become synonymous with higher interest rates than student loans, but the DTI ratio doesn’t account for the difference.
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The DTI formula is relatively simple to calculate. Prospective borrowers simply need to confirm how much they pay each month in revolving bills and how much money they make each month before deductions.
Let’s say, for example, you wanted to apply for a mortgage. Prior to sending in the application, however, you decided to calculate your own debt-to-income ratio to see if you would qualify. In doing so, you would need to add up all of the monthly revolving debt. For this example, you monthly bills look like the following:
Car Payment: $400
Credit Card Payments: $600
Mortgage Payment: $2,000
Added together, your bills amount to $3,000 in monthly debt payments.
Now, let’s say you bring home $5,000 in gross income each month. To determine your own debt-to-income ratio, simply divide the monthly debt ($3,000) by the gross income ($5,000).
How To Calculate Debt-To-Income Ratio
In order to calculate the debt-to-income ratio, prospective borrowers will need to follow three simple steps:
Calculate Minimum Monthly Payments
Divide Monthly Payments By Gross Monthly Income
Convert Result To A Percentage
1. Calculate Your Minimum Monthly Payments
As perhaps the most difficult step, prospective borrowers must add up all qualifying monthly payment minimums. That’s not to say every payment must be included, but rather that the debt-to-income ratio accounts for regular, required, and recurring bills. It is important to note that the debt-to-income ratio only accounts for minimum payments; not account balances or extra payments. The banks merely want to know the minimum payment obligations per borrower. That said, the most common payments include, but are not limited to:
Homeowners insurance premiums
Credit card payments
Again, the monthly payments applied to the debt-to-income ratio are regular, required, and recurring. As a result, there are many payments which aren’t applied to the DTI formula:
Health insurance premiums
Borrowers won’t know how to calculate the debt-to-income ratio if they can’t identify which costs are included. Therefore, take a look at the costs above and extrapolate the ones that apply. Once you have a better idea of qualifying monthly expenditures, you may move on to the second step.
2. Divide Your Monthly Payments By Your Gross Monthly Income
The second step isn’t nearly as convoluted as the first. In fact, all prospective borrowers need to do is look at their last paycheck and determine their gross monthly income. To be clear, the gross monthly income is the amount before taxes are taken out; that’s an important distinction to make because gross income is larger than net income. Once the gross income has been determined, divide the cumulative monthly payments by the gross monthly income.
3. Convert Your Result To A Percentage
Upon dividing the qualifying debt obligations by the gross income, borrowers will be given a quotient in the form of a decimal. Since the debt-to-income ratio is a ratio, however, borrowers must turn the decimal into a ratio (otherwise known as a percentage). To do so, simply multiply the quotient by 100. The rustling number will be expressed as a percentage, and borrowers will finally see their debt-to-income ratio.
What Is A Good Debt-To-Income Ratio For A Mortgage?
The debt-to-income ratio mortgage approval process will vary from loan to loan. Not unlike a credit score, for example, some lenders are willing to accept higher debt-to-income ratios than others for their respective services. If for nothing else, some lenders are more risk averse than others, while their counterparts are more comfortable taking on an accepted level of risk. What’s more, some loans are even backed by the government, which allows some lenders to take on more risk.
All things considered, a good debt-to-income ratio will change depending on the loan being applied for. Having said that, here’s a look at what most loans deem an acceptable debt-to-income ratio:
FHA Loans: The Federal Housing Administration accepts debt-to-income ratios as high as 57.0%.
USDA Loans: The United States Department of Agriculture accepts debt-to-income ratios as high as 40.0%.
VA Loans The Department of Veterans Affairs accepts debt-to-income ratios as high as 60.0%.
Conventional Loans: Most conventional loans accept debt-to-income ratios as high as 65.0%.
How To Lower Your Debt-To-Income Ratio
At first glance, lowering your debt-to-income ratio is as simple as doing two things: making more money and decreasing monthly bills. Not surprisingly, however, doing both is easier said than done.
In the event your DTI ratio is too high, the first step you should take to lower it is to pay off small bills. Any borrowers awarded the luxury of being able to pay off their smallest debt obligations should do so if they hope to see an immediate drop in their debt-to-income ratio.
Taking it a step further, borrowers should look to try and increase their monthly income. Reporting a higher monthly gross income will lower the DTI ratio. While increasing your income isn’t necessarily the easiest thing to do, borrowers can attempt to do anything from asking for a raise to picking up more hours at work. It is worth noting, however, that lenders will want to see a proven track record. It’s not enough to increase hours for a few weeks; it needs to be for a prolonged period of time and sustainable.
If neither paying off debts or increasing gross income is an option, there’s always the possibility of adding someone else to the loan. When two people are on the same loan, the lender will calculate the gross income of both parties relative to the debts. In the event the debts are shared, the borrowers may be able to lower their debt to income ratios.
As an aspiring homeowner, it’s not enough to simply know the DTI meaning; you need to simultaneously know how to lower it and understand just how it impacts your ability to receive mortgage approval. Once you know what influences the DTI ratio, you can take the appropriate steps to fix it. Hopefully this guide has given you the tools and answers necessary to improve your chances of receiving a loan.
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