One major factor lenders consider when reviewing your mortgage application is your debt-to-income ratio (DTI).
Essentially, how much of your paycheck goes toward paying down debts.
A lower DTI tells lenders you have a healthy reserve to draw on and will earn you approval and a good mortgage rate.
A higher ratio, however, could suggest you're a big risk to a lender.
What is a debt-to-income ratio?
Lenders want borrowers who can keep up with their mortgage payments. One way they find them is by looking at applicants' current debt load.
There are two types of debt-to-income ratios and lenders may look at either (or both):
- Front-end DTI: This only includes housing expenses, like your rent or mortgage payment, property taxes and homeowners insurance.
- Back-end DTI includes all debt payments, including housing.
Eligible payments for back-end DTI include:
- Rent or mortgage
- Credit card balances
- Car loans, student loans, personal loans
- Home equity loans or HELOCs
- Child support or alimony
Payments that don't factor into your back-end DTI:
- Groceries
- Utility bills
- Health insurance
- Gas or transportation
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How to calculate your debt-to-income ratio
To determine your debt-to-income ratio, divide your total monthly debt payments by your take-home pay.
For example, if you pay $500 in student loans every month, $400 for your car payment and $100 goes toward your credit card, that's $1,000 in monthly debt.
If your take-home pay is $5,000 a month, you would divide $1,000 by $5,000 and get a DTI of 20%.
What's a "good" debt-to-income ratio?
According to the "28/36 rule," you shouldn't spend more than 28% of your gross monthly income on housing and no more than 36% on all debts combined.
A DTI ratio of 36% or less will almost surely get you the best rates. Lenders generally prefer a ratio of 43% or less, but may approve borrowers with DTI ratios up to 50%, especially if they have good credit or significant cash reserves.
How to lower your debt-to-income ratio
If you're worried that your DTI will prevent you from getting the best rate, the first thing to do is start paying down your debts. (Well, that or get a raise.)
There are several approaches to tackling outstanding debt.
The avalanche method
Start by paying down the debt with the highest interest rate. Once that's paid off, move on to the bill with the second-highest rate, and so on. Following the avalanche method, you should end up paying less in interest overall.
The snowball method
With the snowball method, you pay off the smallest balance first and then move on to the second smallest balance, and so on. The theory here is that knocking out easier targets first gives you more encouragement to stay on track climbing out of the red.
Refinancing
You may be able to refinance your student loans or auto loans. If clearing debt is your goal, aim to lower your rate or pay off your balance faster. That way, you'll pay less in interest over the life of the loan.
Autopay is one of our top picks for auto refinancing, with options for traditional and cash-back refinancing, as well as lease buyout option to pay off your lease early.
- Broad loan amount range
- Open to borrowers with bad credit and co-applicants
- Prequalification available
- Loan repayment terms up to 96 months
- Can defer first payment for 45 days
- Loan approval may take up to 48 hours
- Funding can take up to two weeks
Debt consolidation
A debt consolidation loan could help with serious credit card bills, since personal loans typically have lower rates than cards. With Happy Money, you can arrange to have your creditors paid directly.
Happy Money's Payoff Loan is a solid option if you're looking to consolidate credit card bills. It offers borrowers with fair credit flexible repayment terms and the option to have the lender pay your creditors directly. The $5,000 minimum may be high for your needs, though, and the origination fee can run from 2% to 12%, which is deducted from your loan proceeds.
Debt-to-income ratio FAQs
how do you calculate debt-to-income ratio?
To determine your DTI, divide your total minimum monthly debt payments by your monthly take-home pay.
What is a good DTI?
A DTI of 36% or less is considered "good" and will help get you the best rate and terms. However, most lenders will accept DTIs as high as 43% or even 50%.
How do lenders use your debt-to-income ratio?
Whether you're applying for a mortgage, a car loan or a credit card, a lender may look at your DTI to see if you can handle more debt. If the figure is too high, you might be rejected or receive a higher interest rate.
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