Debt-to-Income Ratio - What is it? Why does it matter?
Whether you are buying your first home or buying again, chances are you will need to take out some type of mortgage loan. The debt-to-income (DTI) ratio is the way mortgage lenders decide how much money you can afford to borrow. It is said to be just as valuable as your credit score. The DTI ratio is the percentage of your monthly gross income used to pay your monthly debts. The idea is that the more income and less debt you have, the easier it will be for you to make payments and, therefore, lessen the banks' risk to loan you money. Two calculations are involved: a front ratio and a back ratio, written in ratio form, i.e., 33/38.
The first number indicates the percentage of your monthly gross income used to pay housing costs, such as principal, interest, taxes, insurance, mortgage insurance and homeowners’ association dues. The second number indicates your monthly consumer debt, such as car payments, credit card debt, installment loans, etc.
A DTI ratio of 33/38 means that 33 percent of your monthly gross income is used to pay your monthly housing costs, and 5 percent of your monthly gross income is used to pay your consumer debt—so your housing costs plus your consumer debt equals 38%. 33/38 is a common guideline for DTI ratios. Depending on your down payment and credit score, the guidelines can be looser or tighter, and guidelines also vary according to program. For example, a Federal Housing Administration (FHA) loan requires no better than a 29/41 qualifying ratio, while the Veteran's Affairs (VA) guidelines require no front ratio but a back ratio of 41.
Why does it matter? More and more people are taking out student loans or opening lines of credit without thinking about how this is affecting their DTI ratio. In order to meet the requirements for a qualified mortgage, you cannot let your DTI ratio go above 43%. Going above this could jeopardize your ability to secure a loan. Do the work on the front end, so that you are not left scrambling on the back end. In the end, the most effective way of lowering your DTI ratio is paying off your debt.
As much as you monitor your credit, monitor your DTI ratio!
CLICK HERE for a free online DTI ratio calculator