Understanding Debt-To-Income Ratio
As you begin looking at houses and shopping around for mortgages, you're like to encounter the term "debt-to-income ratio" (DTI) pretty often. It's a useful way for lenders to determine your available cash flow - at least in your current financial scenario - and with the information, estimate your ability to make monthly payments on a mortgage. For plenty of lending companies, DTI is one of the most important factors, along with credit score, down payment, and thorough documentation of your finances. So, what is this ratio? How is it calculated? Why does it matter? DTI is actually quite simple. First, find your monthly gross income (your total monthly income before taxes and any other deductions). Then, calculate how much you pay on debts each month - this includes credit cards, car payments, student loans, and so on. Some lenders include other monthly expenses like utilities, insurance, and other living costs.
To find your ratio, just divide your debt by your income!
So, if you make $3000 per month, and spend $1400 per month on debts: 1400/3000 = 0.46666 or a DTI of 47%.
Many lenders look for a DTI of around 36% (or a little over a third of your income spent on debts). This shows that you have a significant portion of income available to make payments on your mortgage.
So, if your DTI is closer to the example provided (47%), how can you improve the ratio? The most direct way is to increase your income - but that's easier said than done for most people. If you can't take on more work or generate more monthly income, the other option is to reduce your debt. For most people, that means delaying the mortgage process until some other debts are paid off. If you're just reducing your monthly payments, you're likely extending the life of those debts - which doesn't do you any good in the long run! The good news is that making the effort to pay off credit card debts, cars, and so on will also improve your credit score!
Fortunately, you can calculate your own DTI well before you ever reach out to lenders or apply for a mortgage. If the numbers aren't ideal, it's time to take some steps to improve that ratio, usually by focusing on paying down debts. Once you can get some of those monthly expenses out of the way (and boost your credit score in the process), you'll be in much better standing for your mortgage application.
The better your DTI and credit score (among some other factors), the more favorable the terms of your home loan will be. Even if you're debt-to-income ratio is in pretty good shape, it still can't hurt review your debts, see what you can pay off in the coming months, and make incremental improvements to your overall financial picture. It's also a good idea to avoid taking on new debts (or making large purchases on credit) right before applying for a mortgage - as this debt will add a payment, and thereby hurt your DTI. Hopefully this helps make some sense of this very common term, and gives you a little more insight into why it's so important - and how to make your own DTI ratio better. It's always worth taking the extra time to get these things in order before you apply for a mortgage - you'll save money in the long run, and have much smoother process for buying your dream home!