Lenders use your debt-to-income ratio to determine if you qualify for a mortgage.
It’s just as important as your credit score, yet it’s an often misunderstood or overlooked measurement of your ability to afford a mortgage.
Your DTI focuses on your income and debts and how they relate to one another. While it feels like another obstacle to qualifying for a mortgage, it protects you from borrowing more than you can afford and risking defaulting on a mortgage.
Here’s everything you must know about DTI ratios.
What is a Debt-to-Income Ratio?
A debt-to-income ratio is a comparison of your monthly debts to your gross monthly income or income before taxes.
It shows lenders how much of your income is already accounted for with and without the new mortgage.
If your DTI is too high, lenders can’t give you a loan because you would over commit your income to too many debts.
If your DTI is close to the limit, you may get approved, but at a higher interest rate or fees to make up for the risk of default. Every lender has different rules.
Fortunately, your DTI is something you can control with a few steps and consistency for the best outcome.
Why is a Debt-to-Income Ratio Important?
Your debt-to-income ratio tells lenders where you stand financially. It doesn’t matter how much money you make; it matters how you spend that money.
You could make hundreds of thousands of dollars a month, but if you have hundreds of thousands of dollars in debt each month too, you wouldn’t be a good candidate for a mortgage because your money is already accounted for.
Lenders use the combination of your credit score, debt-to-income ratio, and your overall finances to determine if you qualify for a loan.
What Debts are Included in your DTI?
Not all debts are included in your DTI. Only those reported on your credit report usually affect your ability to secure a mortgage.
Here are some common examples of debts that are usually included:
- Housing payments (includes principal, interest, real estate taxes, homeowner’s insurance, HOA dues, and mortgage insurance if applicable)
- Car payments
- Student loan payments
- Minimum credit card payments
- Personal loan payments
- Monthly timeshare payments
- Child support or alimony payments
- Co-signed loan payments
What Debts are NOT Included in your DTI?
Not all debts are included in your DTI, which can be good or bad. It’s good because the ‘extra’ bills won’t affect your ability to secure a mortgage. It’s bad because the payments could make it harder to afford your mortgage payment since they increase your overall DTI, just not the one lenders consider.
The following debts are NOT included in your debt ratio:
- Utility bills
- Insurance (car, health, or life)
- Cell phone bills
- Internet bills
- Cable bills
- Dining out or entertainment
These are your cost of living expenses that most people endure.
If you have a high DTI, it could make it harder to make ends meet and afford everything you need on a daily basis, which could put you at higher risk of default
How to Lower your DTI – 4 Steps
The good news is you can lower your debt-to-income ratio. Here’s how.
1. Pay your debts down
The easiest way to lower your debt-to-income ratio is to pay your debts down as much as possible. If you have high-interest credit cards, pay the balance down or off completely. If you have installment debts, pay the balances down enough so that you only have the equivalent of a few payments left. Most lenders won’t include installment loans if there are only a handful of payments left.
2. Stop using your credit cards
Only buy what you can afford to pay in cash. If you keep charging up your credit cards, you’ll keep increasing your DTI. Every time you rack up credit card debt it increases your DTI making it harder to get approved for a mortgage. Rather than charging items, save up for them and pay cash so it doesn’t affect your credentials.
3. Don’t open new loans
If you’re thinking about applying for a mortgage refrain from applying for any other debt, even small personal loans. Every debt you take on increases your DTI. Instead, focus on paying your current debts down or off.
4. Increase your income
This step isn’t as easy and takes more time, but if you plan ahead, it can work. If you know you’re up for a raise at work, it’s the fastest and simplest way to decrease your DTI.
Higher income with stable or decreasing debts will lower your DTI.
If you aren’t up for a raise, you can increase your income by starting a side gig or taking on a part-time job.
However, lenders won’t count this income until you have it for at least 2 years. If you use the extra money to pay your debts down, though, it can help you get approved.
How Debts Affect your Credit Scores
Your debt-to-income ratio isn’t the only thing affected by your debts – your credit score is affected too.
The second largest part of your credit score is your credit utilization rate. This is the comparison of your outstanding credit card debt to your total credit line.
If your outstanding credit exceeds 30% of your credit line it can bring your credit score down and is another reason to keep your debts to a minimum.
When you apply for a mortgage, focus on your credit score and total debts, which go hand-in-hand. The fewer debts you have the higher your chances of getting approved become.
Lenders first look at your credit score to make sure it meets the requirements, but next, they look at your DTI.
If you have a high DTI (higher than 45%), work on lowering it before you apply for a mortgage.
You’ll have a higher chance of not only getting approved but also securing the best rate and terms on your mortgage.
Need help determining what your DTI is? Speak with one of our loan officers. Start the process by completing the form below.
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