Securing a mortgage is one of the most important steps in the homebuying process. The majority of Americans don’t have significant funds to purchase a home in cash. The home loan process is intricate, and lenders consider various factors outside your credit score.
One of the several factors lenders consider is your debt-to-income ratio (DTI). Lenders use this metric in tandem with your credit score to assess the overall risk of loaning you money to finance the purchase of a home.
Specific mortgage options may require the borrower not to exceed maximum DTI requirements. Your debt-to-income ratio can be one of a few reasons you may not qualify for a specific loan or receive favorable terms and rates. In this guide, we’ll outline the two types of debt-to-income ratios, how to calculate your DTI ratio and what DTI ratio is required for some of the most popular home loan options.
What Is Debt-To-Income Ratio?
Debt-to-income ratio is a percentage metric used to calculate your gross monthly income versus your monthly debt payments. The simplest way to determine your DTI is by adding up your monthly minimum debt payments and dividing it by your monthly pre-tax income.
Specific home loan options may have maximum DTI requirements for qualification. A lower DTI generally provides borrowers with various mortgage options and opportunities to receive more favorable terms and rates.
During the mortgage application process, lenders will consider two different types of DTI ratios—front-end and back-end.
Front-end DTI
Front-end debt-to-income ratio is a variation of the DTI calculation to determine how much of someone’s gross income is going toward housing expenses. Lenders calculate front-end DTI using your future monthly mortgage payment, including property taxes and homeowners insurance.
Since front-end DTI is a variation of your overall debt-to-income ratio, there is a specific formula for calculating front-end DTI.
To determine your front-end DTI, you’ll need to add up all your expected housing costs and divide it by your pre-tax income. Once that is complete, you’ll need to multiply the result by 100. That is your front-end DTI.
For example, suppose your housing expenses total $1,000, and your monthly income is $4,000. So, you’ll take $1,000, divide that by $4,000 and multiply that by 100 to arrive at a front-end DTI of 25%.
Generally, lenders prefer a front-end DTI no higher than 28%. Depending on the other factors such as credit score, income and down payment, lenders may accept higher ratios. Although, it may be a deciding factor depending on the type of home loan.
Back-end DTI
Back-end ratio, also known as the debt-to-income ratio, includes all minimum required monthly debts. In addition to housing expenses, back-end DTI incorporates all minimum monthly payments your lender may find on your credit report. That may include credit card debt, student loan debt, auto loan debt and personal loan debt.
Most lenders focus on the back-end DTI because it provides a holistic view of your monthly spending habits.
How To Calculate Debt-To-Income Ratio
Before applying for a mortgage, it’s advantageous to know your debt-to-income ratio. To calculate your DTI, add up all your monthly debts, then divide the total by your gross monthly income. You can use a debt-to-income calculator, but knowing how to calculate your DTI will help you when a calculator is not accessible.
Here is a step-by-step breakdown of calculating your DTI.
Add up your minimum monthly payments
For your DTI calculation, monthly payments should only include ones that are regular, required and recurring. Only minimum monthly payments should be considered, not the entire account balance or the amount you typically pay. For example, if you have a credit card balance of $5,000 with a minimum payment of $110, you should only include the $110 when calculating your DTI.
Some examples of regular, required and recurring debts that are generally included in your DTI are:
- Rent or monthly mortgage payments
- Monthly homeowners insurance premium
- Homeowners association (HOA) fees that are paid monthly
- Credit card payments
- Student loan payments
- Auto loan payments
- Personal loan payments
- Child support or alimony payments
Common expenses that should not be incorporated into your minimum monthly payment calculation include: savings account contributions, 401(k) or IRA contributions, utility costs, health insurance premiums, transportation costs, entertainment, food and clothing costs and other related expenses.
Here’s an example of how to calculate your DTI by adding up your monthly payments. Suppose your minimum monthly expenses are as follows.
- Rent: $700
- Credit card payment: $110
- Student loan payment: $125
- Auto loan payment: $150
In this instance, you would add $700, $110, $125 and $150 for a total of $1,085 in minimum monthly payments.
Divide your monthly payments by your gross monthly income
Once you’ve calculated your minimum monthly payments, you’ll want to determine your gross monthly income. Your gross monthly income is the total amount of pre-tax income you earn per month. If someone else in your household plans to have their name on the loan, you should factor in their income and their debts.
After the total gross monthly income has been calculated for everyone on the loan, you’ll divide the minimum monthly payments by your pre-tax income.
Using the figure above, suppose your total monthly payments are $1,085, and your gross monthly income is $4,500. You’ll take $1,085/$4,500 for a total of 0.24.
Convert the result to a percentage
Since DTI is a ratio, you’ll need to convert the decimal quotient into a percentage. To obtain your DTI percentage, you’ll need to multiply the result by 100. Using the example in the previous section, your total is 0.24. 0.24×100 comes out to 24. This means your DTI is 24%, which is ideal for most home loan options. Lenders prefer applications with a debt-to-income ratio of 36% or less.
What Is The Debt-To-Income Ratio To Qualify For A Mortgage?
Debt-to-income ratio is the opposite of credit scores. The lower the DTI, the better chance you have to obtain a mortgage with favorable terms and rates. Let’s look at some of the most popular home loan options and discuss the DTI requirements.
Conventional loans
Conventional mortgages don’t have a single set of requirements. Credit score and DTI requirements may vary depending on your situation and the lender you choose. However, conventional loan borrowers generally have a DTI of 50% or less. While it’s not common, depending on the circumstance, you may qualify for a conventional loan with a DTI as high as 65%.
FHA loans
FHA loans are a type of government-insured home loan. The Federal Housing Administration backs these loans. Their goal is to make homeownership more attainable for low-income borrowers. Credit score requirements are generally much lower than other mortgage options. The maximum DTI for FHA loans is 43% and 31% for your front-end DTI.
VA loans
VA loans are insured by the Department of Veterans Affairs. They provide loans to veterans, active-duty members and qualified surviving spouses. One of the benefits of a VA loan is no down payment is required. There is no specified DTI maximum requirement to qualify for a VA loan. It’s possible to obtain a VA loan with a DTI as high as 60%.
USDA loans
USDA loans are backed by the United States Department of Agriculture. USDA loans can only be used to buy and refinance homes in eligible rural areas. USDA loans are generally used to make homeownership easier for low-income borrowers. The requirements are more strict than some of the other mortgage options available. To obtain a USDA loan, your DTI must not exceed 41%.
Secure The Home Of Your Dreams With The Help Of Arizona Central Credit Union
Understanding your debt-to-income ratio before you apply for a mortgage may be beneficial. If you determine that your DTI is too high, you can reassess and make a game plan to lower your percentage. However, don’t let a high DTI deter you from the homebuying process. Lenders use various metrics to determine your qualification and their overall risk of lending you money.
If you’re ready to start shopping for a mortgage, consider Arizona Central Credit Union as your home loan provider. We’ve been helping Arizonans finance the home of their dreams for nearly a century. Find out what loans you’re eligible for with our prequalification process. If you want to speak with one of your mortgage loan specialists, visit our Mortgage Specialists page for more information.
