When you go for a mortgage or a car loan or when you apply for a new credit card, in addition to looking at your credit score, many lenders consider your debt-to-income ratio or DTI. This is a big deal in the mortgage industry, but can also affect your ability to get a loan or line of credit with other lenders.
While your credit score and credit history determines, in large part, your interest rate, your DTI may affect whether or not you can secure the loan and, if so, how much credit a lender will extend.
There are two types of debt-to-income ratios; one considers the amount you spend on housing, and the other looks at your overall debt. When lenders calculate your DTI, they look at your gross annual income in relation to your debt and some other fixed expenses.
You’re actually spending a greater percentage of your take-home pay to pay your debt.
So if your DTI is 25%, but you still feel like you have no money left after paying your mortgage, car loan and credit card bills every month, that may well be the truth! (If this is the case, you’ll want to look at your flexible expenses, like groceries and entertainment, to see where you can cut in order to get out of debt faster.)
Let’s take a look at both DTIs, the front-end ratio and the back-end ratio.
Debt-to-Income Ratio, Front-end
The front-end ratio looks at the percentage of your gross income that goes toward housing, whether you rent or own.
For renters, this number is your gross income divided by your monthly rent.
For homeowners, it’s the “PITI” — the mortgage principal and interest, mortgage insurance premium (PMI) if your mortgage represents more than 80% of your home’s value, homeowner’s insurance premiums, property taxes and any homeowners’ association dues. Essentially, it’s the amount you pay to the bank holding your mortgage every month.
Most lenders look for this number to be 28% or less, although you may be able to get an FHA loan with a front-end DTI as high as 31%.
Debt-to-Income Ratio, Back-End
This number, which lenders like to see at 36% or less, looks at the percentage of your income that goes to all your recurring debt. This includes:
- Your housing costs, or your front-end DTI, plus…
- Minimum monthly credit card payments
- Car loan payments
- Student loan payments
- Child support and/or alimony payments
- Legal judgments, including outstanding tax bills
This number does not include living expenses such as food, gas, utilities or car insurance.
Don’t Confuse DTI with Debt-to-Available Credit Ratio
It’s important to remember that your DTI has little to do with the “debt-to-available credit ratio” that shows up on your credit reports. That latter figure takes into account your credit card debt compared to your credit limits, and the starting amount on other loans (such as car loans and mortgages) versus how much you have already paid off.
Your DTI does not show up on your credit report. Mortgage companies calculate it based on your pay stubs and tax forms, while other lenders just look at the number you write down for “gross monthly income” on your credit card application.
How Can Knowing Your DTI Help You?
Like your credit score, your DTI gives you a snapshot of your financial health. If your DTI falls within the range considered healthy by lenders, your overall financial situation is probably not bad.
Of course, consider your DTI and overall financial picture with common sense, too.
If you have no other debt — your car is paid for, no student loans, and no credit card debt — maybe you own a nicer house and are spending a bit more money on it. That doesn’t mean you’d be able to secure a mortgage representing 36% of your gross monthly income, but it does mean you’re handling your finances well. (In that situation, you could take all the money you’re saving by not having debt and make a larger down payment on the house of your dreams).
If your DTI is extremely high due to credit card payments and other loans, you’ll want to begin cutting expenses and paying down your debt.
Making more than the minimum payment on your credit cards can really go a long way toward improving your DTI by lowering your monthly minimum payments over time — and save you thousands of dollars in interest every year!