Why You Need to Know About Debt-to-Income Ratio

Your debt-to-income (DTI) ratio measures the percentage of your monthly gross income that you use for debt payments. Gross income is your paycheck before any deductions, such as taxes and insurance. As your DTI ratio rises, so does your riskiness in the eyes of lenders. If it gets too high, you might lose your access to credit.

DTI Calculation

The DTI calculation is simple:

DTI = 100 x (Total Monthly Debt Payments / Gross Monthly Income)

The debt payments include those arising from various sources, such as:

• Mortgage or rent payment

• Minimum student loan payment

• Personal loan payment.

• Car loan or lease payment(s)

• Minimum credit card payment(s)

• Child support and other required regular payments

Divide the sum of your monthly payments by your monthly gross. Finally, multiply the result by 100 to convert from decimal to percentage.

For example, suppose you have the following monthly debt payments:

• Mortgage (including PMI): $1,200

• Personal loan: $225

• Credit card minimum payments: $75

Your total monthly debt payments amount to $1,500. Your gross salary is $5,000. Therefore, your DTI ratio is 100 x ($1,500 / $5,000), or 30%.

Significance of DTI Ratio

Lenders and creditors set certain requirements for applicants to receive a loan or credit card. Commonly, one of those requirements is to have an acceptable DTI ratio. While certainly not the only consideration, creditors look closely at DTI to judge your creditworthiness. Their primary concern is default risk — the risk that you won’t make your payments on time and in full. If the preponderance of the evidence, including DTI ratio, suggests a negative answer, creditors will either reject the application outright, offer a smaller amount, and/or charge a higher interest rate.

DTI Ratio and Mortgages

Typically, mortgage lenders will not lend to applicants with DTI ratios above 43%. In fact, most mortgage lenders want to see a DTI ratio below 36%, of which no more than 28% goes toward servicing a mortgage or paying rent.

In order to get an FHA-insured mortgage, you must satisfy certain specific criteria regarding DTI:

• Front-end ratio: this is DTI that is modified to look at only housing-related debts (mortgage, rent, property taxes, PMI, HOA fees, etc.). The FHA maximum front-end ratio is 31%

• Back-end ratio: this is the standard DTI figure that includes all monthly debts. The FHA maximum back-end ratio is 43%. However, certain borrowers - those with good credit and other positive compensating factors - might qualify for an FHA-insured mortgage with a back-end ratio as high as 50%

The DTI expresses the two ratios as front-end/back-end, such as 31/43. If you fail to meet either of these criteria, you might not qualify for FHA insurance. However, if you’re looking to finance an energy-efficient home (as defined by the Department of Housing and Urban Development), the maximum DTI ratios stretch to 33/45.

The compensating factors that can increase your maximum allowable DTI ratio include:

• Credit scores: A credit score above 580 will raise your maximum DTI ratios to 40/40 if you have no discretionary debt. This means the following must be true:

  • Your only account with an open balance is for your housing payments

  • You haven’t opened a new credit line in the past six months

  • Preexisting credit accounts must have been fully repaid for at least six months

• Other factors: You might qualify for 40/50 maximum DTI ratios if you meet two of the following four criteria:

  • Your new mortgage will involve little or no increase in your monthly housing payments. That is, your monthly housing payments will not increase by more than $100 or 5%, whichever is less

  • You have sufficient cash reserves that are verified and documented. In this case, that means having one to three months of mortgage payments (including mortgage insurance) in the bank following closing on the new mortgage

  • You have substantial additional income besides your gross paycheck. This includes income from bonuses, overtime, seasonal employment or part-time income. Its a compensating factor if you’ve received this additional income for at least one year and will most likely continue to receive it. Additionally, the income, if included, would reduce your DTI ratios to no higher than 37/47

  • You have significant money left over after paying all your monthly debts and expenses

DTI Ratio and Credit Scores

A common misconception is that a high DTI ratio will lower your credit score. In fact, credit scores do not reference income, so DTI is not a factor. However, credit utilization ratio (CUR) is most definitely a factor determining credit score. CUR is the percentage of credit you currently use versus the amount you’ve been authorized. Although DTI isn’t involved in your credit score, it is factored in when seeking new credit, such as a new credit card.

DTI Ratio Limitations

The DTI ratio is important but is only one of several significant data points. Lenders and creditors also examine your credit score and credit history when evaluating your creditworthiness. These include other factors, such as late payments, defaults, collections, liens, foreclosures, and bankruptcies. Creditors also look at credit utilization ratio, the number and age of your open accounts, and whether you have several forms of debt.

Another limitation of the DTI ratio is that it doesn’t account for different interest rates. For example, a mortgage might charge a 5% rate, whereas your credit card might have an APR near 30%. Obviously, the cost of servicing your debt is an important factor in assessing your creditworthiness. This implies that it’s a good idea to transfer debt from expensive sources to cheaper ones. For example, many credit cards offer an introductory period of 0% interest on balance transfers (although they do charge a transfer fee). You could arrange a transfer and lower your DTI ratio without affecting your overall indebtedness.

Conclusion

If your DTI ratio is high, it would behoove you to lower it. Typically, there are two ways: Increase your gross income or reduce your monthly debt payments. Bringing down your DTI ratio will help improve your creditworthiness and give you better access to low-cost debt.