If you're planning to buy a home, your lender will probably use your debt-to-income ratio as part of the qualification process. In simple terms, this tells the lender how "affordable" the home is, given your current income and other debts.
Here's a rundown of what you need to know about the debt-to-income ratio, how to calculate yours, and how you can use your debt-to-income ratio to determine how much house you can afford.
What is your debt-to-income ratio and why does it matter?
Your debt-to-income ratio, or DTI ratio (you’ll see both here), is an important part of the mortgage approval process.
Lenders look at a few things when deciding whether to approve your mortgage application. They’ll generally check your credit score, your assets, and your employment history. They’ll also look at your income and how affordable a particular home would be for you. This is where the debt-to-income ratio comes in.
There are two types of debt-to-income ratios your lender might use:
- Front-end DTI: This is the percentage of your income that will be used to cover your new mortgage payment. For example, if you hear your lender say that your new housing payment can’t be more than one-third of your income, that’s a form of a front-end DTI ratio.
- Back-end DTI: This is the percentage of your income that you’ll need to pay all of your debts, including your new mortgage payment. The back-end DTI is more important and lenders often simply referred to as your debt-to-income ratio. It’s not surprising -- it’s your overall debt picture that determines whether you can comfortably afford a certain home, not just your new mortgage payment.
Here’s a rundown of how you can calculate and interpret your own DTI ratios.
Calculating your front-end DTI ratio
Front-end debt-to-income ratio is the less important of the two in practice. However, many lenders still calculate it, so it's worth mentioning here. In short, while your overall debt picture is the better determining factor when it comes to affordability, lenders also want to make sure you won’t get in over your head with your housing payment alone.
The front-end DTI is the easier ratio to calculate. Simply take your expected mortgage payment, including principal, interest, taxes, insurance, and any HOA dues, and divide it by your monthly pre-tax income.
Say your monthly loan payment on a particular home will be $1,000 per month and your monthly income before taxes is $5,000. Dividing the two gives you a front-end DTI ratio of 20%.
Calculating your back-end DTI ratio
The back-end DTI ratio includes your new mortgage payment as well as all of your other monthly debt obligations. To calculate it, add up all of your monthly obligations and divide by your pre-tax income.
However, it’s not quite as simple as this makes it sound. Here are a few guidelines to keep in mind:
- Only certain debts are considered for DTI purposes. This includes auto loans, student loans, credit cards, and other loan payments. It does not include things like your utility bills, auto insurance, monthly memberships and subscriptions, or similar expenses. A good rule of thumb is that if something isn’t regularly reported to the major credit bureaus, it isn’t considered in the DTI calculation.
- For credit card debts, only consider the minimum payment you’re required to make, not the amount of the debt or how much you actually plan to pay.
- Lenders can consider student loans differently. If your loans are in deferment or you’re on an income-driven repayment plan, some lenders will use your required payment. Others consider the amount you'd pay under a standard 10-year repayment plan. Check with your lender for their specific policy or err on the side of caution and use the full payment amount.
- If you have an existing mortgage and you’re planning to sell your home to buy a new one, you can typically exclude your current mortgage payment from the calculation if your new home purchase is contingent on selling your current one.
Here’s an example of how this might work. Continuing the example from the previous section, we’ll say that your new monthly housing payment will be $1,000 per month and that your pre-tax income is $5,000 per month.
We’ll say you have a $400 monthly car payment, $300 student loan payment, and that the minimum payments on your credit cards add up to $100 per month. Adding the $1,000 mortgage payment gives you a total of $1,800 of monthly debt obligations. Dividing this by your income gives a back-end DTI ratio of 36%.