Mortgage Monday: What is Debt-to-Income Ratio?
What is debt-to-income ratio? This equation, comparing how much money you owe to the money you make, affects whether you can qualify for a mortgage—but let’s unpack this important term into plain old dollars and sense.
You know what debt and income each mean independently. Debt is money you owe to another party. As a consumer, your debt load is what you owe in obligations like credit card payments, student loans, car loans, installment loans, car loans, personal debts, alimony, or child support. Meanwhile, income is the sum of the money you make from your job, part-time work, alimony, or income-producing assets such as real estate or stocks.
So, what do debt and income have to do with obtaining a home loan?
What is debt-to-income ratio?
Your debt-to-income (DTI) ratio helps lenders figure out how (or whether) a home purchase can fit into your financial picture. To calculate your DTI ratio, you simply divide your ongoing monthly debt payments by your monthly income.
For revolving debt like a credit card, use the minimum monthly payment for this calculation. This might not match what you typically pay each month—hopefully, you're paying off your credit cards as quickly as possible, in order to reduce how much money you pay in interest—but the minimum payment is what most lenders use when calculating DTI.
For installment debt, which is money you owe in fixed payments for a fixed number of months—such as installments you owe on the washer/dryer or A/C unit you purchased—use the current monthly payment.
So, let’s say you're paying $500 to debts and pulling in $6,000 in gross (meaning pretax) income. Divide $500 by $6,000 and you've got a DTI ratio of 0.083, or 8.3%. However, that's your DTI ratio without a monthly mortgage payment. If you factor in a monthly mortgage payment of, say, $1,000 per month, your DTI ratio increases to 25%.
Why does it matter?
Lenders use your DTI ratio to assess your ability to pay for a loan. Lenders like this number to be low. Why? Because evidence from studies of mortgage loans shows that borrowers with a higher debt-to-income ratio are more likely to run into trouble making monthly payments, says the Consumer Financial Protection Bureau (CFPB).
As a general rule, if you want to qualify for a mortgage, your DTI ratio cannot exceed 36% of your gross monthly income, says David Feldberg, broker/owner of Coastal Real Estate Group in Newport Beach, CA. A higher DTI ratio could mean you’ll pay more interest, or you could be denied a loan altogether.
Some lenders will loan money to people with DTI ratios exceeding 36%, but it's rare. After all, if you default on your mortgage and your lender has to foreclose on your home, your lenders may not be able to recoup their full investment. And it's bad for you too: As a borrower, defaulting on your mortgage can destroy your credit score, which would make it more difficult for you to qualify for another mortgage.
To verify income, a mortgage lender will want to see recent pay stubs and W-2 tax forms for the past two years. If you’ve recently had a change in pay, such as a raise, you’ll need to get a statement from your boss confirming your new salary. And, if you generate income from a source outside your primary job—such as part-time work or side gigs that pay only commission—you’ll have to provide W-2 forms for these as well.
To verify debt, you’ll have to provide official documents, such as credit card statements, that show the debts you currently owe.
How much home can I afford?
Curious what price home fits within your budget? Try a Home Affordability Calculator. It lets you plug in important financials, including your debt, income, and down payment, and uses your location to determine today’s interest rate, the tax rate in your area, and the cost of home insurance. Once you have that information, you can connect with a mortgage lender that will help you get a home loan.