When a mortgage lender reviews your loan application, the first thing they do is assess your ability and willingness to repay the loan.
During the review, lenders look at several data points on your loan application, including your employment history, down payment, liquid assets, and collateral. However, the information that interests them the most is your credit history, your credit score, and your debt-to-income ratio.
These data points are the most accurate indicators of risk because they provide insight into how you managed debt in the past and how financially capable you currently are of taking on additional debt. If you are thinking about applying for a home loan, you can help streamline the process by proactively assessing your ability to comfortably add the financial responsibility of a home. Knowing how to calculate your debt-to-income ratio is a great place to start.
What is debt-to-income ratio?
Debt-to-income ratio, or DTI, is a comparison of how much money you owe each month to how much money you earn. In other words, it's the percentage of your gross monthly income that goes toward expenses such as rent or your current mortgage, credit cards, car payments, student loans, and other debt. If you are applying for a VA loan, the lender will also factor taxes and childcare expenses into your DTI.
Your DTI is significant when applying for a loan, especially a home loan, because lenders use the information to evaluate how financially capable you are to take on more debt. The lower your DTI, the lower the perceived risk to the lender because, at least on paper, you have the financial capacity to make your loan payment every month.
How do you calculate debt-to-income ratio?
To calculate your DTI, you first need to take an inventory of all of your monthly debt, including housing, credit cards, and student loans. You can exclude expenses such as utility payments, car insurance, and internet service.
Once your debt inventory is complete, you plug the numbers into a simple formula:
DTI = (Monthly debt payments/Gross monthly income) x 100
For example, suppose each month you pay $1,500 for your mortgage, $500 for your student loan payment, and $300 for credit card bills. Your total monthly debt payments are $2,300. If your gross monthly income is $5,000, then your debt-to-income ratio can be calculated as ($2,300/$5,000) x 100 = 46 percent.
What is considered a ‘good’ debt-to-income ratio?
There is no standard value for debt-to-income ratio. Every lender has its own risk tolerance and sets its own limit. However, within the home loan industry, “good” DTI normally falls between 30 percent and 50 percent, with 43 percent being the cap for many lending institutions.
A higher-than-preferred DTI doesn’t automatically disqualify you from a home loan. Other factors, such as a high credit score and having a substantial amount of verifiable cash, may help you get a loan even with a less-than-ideal DTI.
Additionally, some loan providers, such as BNC Mortgage Lenders, take a one-on-one approach to lending, treating every customer as an individual and helping them find unique mortgage solutions even with high or nuanced DTI ratios.
How can you improve your debt-to-income ratio?
If you complete your debt inventory and discover your DTI is too high, don’t be discouraged. Unlike a poor credit score, there are ways to improve your DTI relatively quickly.
Because DTI is a comparison of your income with your debt, you can increase your monthly income, decrease your monthly debt, or do both. Asking for a raise at your current job is essentially your only practical option for generating additional income quickly. So, it’s normally more effective to look for ways to reduce your debt.
To pay down debt and improve your DTI, try picking up additional shifts or working longer hours if that is an option in your workplace. If you can’t increase your hours, consider getting a second job, even temporarily, to increase the amount of cash you have to apply to your debt.
Even if you aren’t able to bring in more money, you can probably find a way to spend less and free up cash that can be put toward existing debt.
One of the most effective ways to cut your spending is to create a budget and stick to it. However, you may find after you make your budget that there isn’t any money left over. In this case, take a close look at your outflow and cut back on unnecessary expenses such as restaurants, coffee shops, and multiple streaming services, or sell household items you no longer use.
If your DTI is significantly impacted by high medical debt or credit card bills, try contacting the provider and asking if they offer reduced buy-out prices if you pay off your debt in a lump sum. That’s a fast and easy way to potentially reduce your debt by hundreds, or even thousands, of dollars.
[NOTE: At BNC National Bank, we are experts at mortgages, not financial advice. Always check with a licensed financial advisor before making major financial decisions.]
Put your debt-to-income ratio to work for you.
Your debt-to-income ratio plays a large role in the type of home loan you qualify for as well as the terms of the loan, including interest rate, down payment, and repayment period. Now that you know how to calculate debt-to-income ratio, you may be wondering whether your DTI is going to hold you back on your journey to homeownership. Let BNC help you find the answer.
Contact us, and a member of our highly experienced BNC Mortgage Lenders team will be in touch to help you navigate the home loan application process and find the mortgage loan that best fits your needs.
About the Author
BNC National Bank
We’re honored to be your partner in the homebuying process. And like any good relationship, it helps to know who you’re working with. A home is the most important purchase we can make in a lifetime. At BNC, we’re built to deliver exceptional customer service from your first call to your closing day and beyond. BNC National Bank has helped families find the right loan to fit their needs for decades.