Your debt-to-income ratio is the most important number when you’re applying for a home loan. Not your credit score. This may come as a surprise.
Again, what matters most is what percentage of your income goes towards paying debt.
The debt-to-income(dti) ratio is the amount of money you owe compared to the amount of money you make. Lenders use this ratio to determine how much money you can afford to pay each month on new debt
If your lender determines that your ratio is too high, they may require you to get another job or make some changes in your budget before agreeing to extend financing to you.
Let’s take a closer look at what this means and how it applies to you when getting a mortgage or loan.
How to Calculate Your Debt-to-Income(DTI) Ratio?
The formula for calculating the debt-to-income ratio is:
Outstanding Debt ÷ Monthly Income = Debt-to-Income Ratio.
- Your gross monthly income is $4,000 a month
- Your monthly debts total $1000
- Your debt-to-income ratio would be 25%.
What Counts as Debt for Your Debt-to-Income Ratio?
Any money you owe , regardless of its interest rate, will count as debt in the debt-to-income ratio. This includes credit card debt, car loans, student loans, and more. Usually things that are reported on your credit report. Utilities, cell phone bills, transportation etc…is usually not counted.
What Is a Good Debt-to-Income Ratio?
A lender can set their own guidelines for a minimum debt-to-income ratio, but generally speaking, the lower your debt-to-income ratio, the better.
If you have a high debt-to-income ratio, you can still get a loan, but it may come with additional requirements, like a higher down payment.
Depending on the type of loan: VA loan, Conventional Loan, FHA Loan, the lender will want to ensure that your DTI ratio is below a certain percentage.
A ratio of 36% or lower is considered good because it shows lenders that you have extra room to increase your payment in the future should interest rates increase. This means that your budget will be more flexible as a result.
Generally speaking, it should be below 43%. However, FHA loans allow for a higher DTI ratio of up to 50%.
But ask yourself whether you would be comfortable using half your salary to pay your mortgage. It’s probably not a good idea.
Keep in mind, the lender uses your gross monthly income, in other words, before taxes are taken out. So your take homer pay is actually less than the number your lender uses, which means you’ll have even less money to pay the mortgage.
When a High Debt-to-Income Ratio is Okay
A high debt-to-income ratio is okay when you have substantial assets to back it up. Lenders will look at the equity in your home, cash savings, investments, and retirement funds when determining whether to approve your mortgage application.
If you have significant assets to back up your high debt-to-income ratio, you may have more options when it comes to choosing a mortgage. If you have a high debt-to-income ratio and little in the way of assets, you will likely have fewer options when it comes to choosing a mortgage.
To summarize, focus on improving your debt to income ratio. You can get a home loan with a credit score as low as 580. That said, you should aim for a 620.
Your credit score only affects the interest rate on the loan the mortgage lender gives you. It is your DTI that will determine whether you get a loan, and for how much.
There’s no point in having a perfect credit score if you make little to no money. Conversely, you could make a ton of money, $1MM/month but also have monthly debt of $999,000. You will not get a loan because your DTI is too high.