Receiving the deed to a home is a major milestone. Typically, it depends on an earlier milestone: the mortgage approval.
Apply for a mortgage, and lenders will consider your debt-to-income ratio (DTI). Why the DTI? Essentially, the lender wants to know how much of your earnings you spend, using credit. A low DTI suggests that you can comfortably make payments.
If your existing debt load is light, you’ll be able to borrow more and spend more on a home. But even if you’re not getting ready to buy a home right now, a lower debt-to-income ratio can unlock financial opportunities. This matters to every one of us.
Let’s see what goes into the ratio, and how to optimize your DTI.
How to Calculate Your DTI
It goes like this. Say you want to buy a condo. How much debt will you be carrying? The mortgage lender will look at your potential mortgage payments as part of the D in DTI.
Say you expect to pay $1,500 a month for housing — including your mortgage loan. Everything else you put on credit each month (car and/or student loan payments, credit card bills) adds up to $1,000. Your monthly debt, then, is $2,500. Note: The D in DTI is the sum of all of your accounts’ minimum monthly payments.
Divide that number by your monthly income (before taxes). Imagine your income is $6,000 a month.
Because $2,500 is approximately 42% of $6,000, your debt-to-income ratio is about 42%. Is that a good DTI?
You want a number as far below 50% as possible, to present a low risk to lenders.
When you begin your own calculation, you’ll note that the more money you put into your down payment, the lower your mortgage payments need to be, and the lower your DTI ratio. But use caution with your down payment decision. You don’t want to deplete all your savings. A relatively high DTI ratio could be fine with a lender, if the borrower shows substantial mortgage reserves. Mortgage reserves are savings you’ve set aside to cover monthly payments in case you experience unexpected financial difficulties.
What about the I in DTI? Income is the other side of the ratio. A nice, low DTI ratio opens the door to better loan terms — lower fees and interest rates. Yet you’ll also need to demonstrate a steady stream of reliable income to bring a mortgage within reach.
According to LendingTree, holding a DTI ratio down under 45% can help a loan applicant get the best rates on private mortgage insurance (PMI). Lower PMI payments mean less debt!
What Kind of Loan Is Best
DTI requirements can vary from loan type to loan type. Some lenders are more flexible than others. But here’s the main thing. Lenders reject overextended applicants.
First, do a little reading up on possible down payment assistance plans for residents of your state and at the county or city level. Your search could lead you to the perfect loan options.
Typical lenders expect a DTI ratio under 49%, with government-backed loans being more flexible for people with relatively high DTI ratios. In other words, if you have relatively high monthly debt, you might have better success applying for a government-backed mortgage from:
- The Department of Veterans Affairs (VA);
- The Federal Housing Administration (FHA); or
- The Department of Agriculture (USDA).
Expect to pay private mortgage insurance if you do this.
But if, instead, you can push that ratio down to 35% or lower, you’re really in clover. Lenders look at applications with under-35% DTIs as good ratios. And the better your overall credit profile, the better interest rates you can snag.
Coming back into the market after a long time, or just starting out? Check out what all first-time home buyers need to know.
How to Lower Your DTI Ratio
If your DTI ratio could derail your mortgage approval, consider how one or more of these moves might help:
- Increasing the down payment you’re willing to make. This could mean accepting a gift of down payment funds. Or it could mean dipping into your retirement account (assuming, of course, that you have enough time before you retire to replenish your funds and absorb any tax penalties for early withdrawals).
- Making sure you’re getting all possible breaks from your homeowner’s insurer. Your insurance costs factor into your housing costs. Lowering your bills helps to ease your debt-to-income ratio.
- Reducing your credit card debt. Say “no” to new credit accounts. Well, mostly. Holding diverse types of credit is a good thing, from a lender’s point of view. An experienced mortgage consultant can give great tips in this area. They might suggest opening a major credit card account, as doing so can lift an applicant’s credit profile.
- Adjusting the amount of credit you’re using, versus your credit limits. Strive to keep your spending below 30% of the account limits.
- Applying for a 30-year loan term instead of a shorter term, so your monthly mortgage payments will be smaller.
- Consolidating your credit card debt. This means combining multiple monthly debts into a personal loan. To lower debt, you would want to refinance your balances into a new credit card with a lower rate than your existing credit cards carry.
And because desperate times may call for extraordinary measures, house hacking is worth a mention. House hacking means renting out part of the space to obtain income and shrink your mortgage debt. It’s not for everyone — but it is yet another way to reduce a real estate buyer’s DTI ratio.
You need a mortgage with sensible terms. How can you make it happen? You might just need a little credit repair.
How to Get There From Here
Mortgage applicants with debt over 43% of their total income may struggle to win approvals. If you’re in this situation, you may need to work on lowering your debt before applying for a mortgage. Talk with a mortgage consultant as your goal takes shape. Experienced professionals can point out the most fast-acting changes you can make.
You might find it easiest to start by naming your goal. Maybe you want a house in a given location for $250-275K. Ask what DTI ratio you will need, and what kind of a down payment you’re looking at.
Proving creditworthiness can be a struggle for first-time buyers. At least know this: it gets easier! After that first-time purchase, a homeowner can build a strong credit profile just by making regular mortgage payments.
Supporting References
Consumer Financial Protection Bureau via ConsumerFinance.gov: Ask CFPB – What Is a Debt to Income Ratio?
Amanda Push and Denny Ceizyk for LendingTree via LendingTree.com:Debt Consolidation – What Is a Good Debt Income Ratio? (May 23, 2023; last reviewed Aug. 28, 2023).
Denny Ceizyk and Rebecca McCracken for LendingTree via LendingTree.com:What Is PMI? Everything You Need to Know About Private Mortgage Insurance (updated Jan. 25, 2023).
Deeds.com: Applying for a Mortgage? Get the Facts on Credit Scores and How to Improve Yours (Nov. 20, 2202).
And as linked.
More on topics: Mortgages, Federal mortgage subsidy, High interest rates
Photo credits: Towfiqu Barbhuiya and Mikhail Nilov, via Pexels/Canva.