Buying a home is a huge financial milestone, and it’s likely the most expensive purchase you’ll ever make.
That’s why most Americans start with a down payment upfront, and then finance the rest through a mortgage. One of the main ways that mortgage lenders determine the amount of the mortgage a home buyer is approved for is to use the buyer’s debt-to-income ratio.
Read on to learn more about why debt-to-income ratio is so important during the homebuying process and how to calculate yours.
What is Debt-to-income ratio?
Debt-to-income ratio (DTI) is the percentage that represents how your monthly debt payments compare to your overall gross monthly income. Gross income is the amount of money you earn before taxes and other deductions are taken out. Debt payments can include mortgages, auto loans, student loans, medical debt, credit card debt, and personal loans.
How Do You Calculate Debt-to-income Ratio?
To calculate your debt-to-income ratio, start by adding up all your monthly debt payments, such as mortgages, student loans, car payments, and credit cards. Once you have this number, divide it by your gross monthly income.
For example, if you pay $250 a month toward student loans, $150 a month toward an auto loan, and $100 a month for payments on outstanding credit card debt, your total monthly debt is $500 ($250 + $150 + 100 = $500). If your gross monthly income is $5,000, then your debt-to-income ratio is 10 percent ($500 / $5,000 * 100 = 10%).
You can also use an online calculator to calculate your debt-to-income ratio.
Why Does Debt-to-income Ratio Matter in the Homebuying Process?
Mortgage lenders want to minimize the risk of borrowers defaulting on the loan. Borrowers with a high debt-to-income ratio are more likely to struggle to pay off their debts, while those with lower debt-to-income ratios tend to have more money available to manage their debt.
According to the Consumer Finance Protection Bureau, the highest debt-to-income ratio a borrower can have and still get a Qualified Mortgage is 43 percent. However, lenders generally prefer that a borrower’s total debt-to-income ratio does not exceed 36 percent.
So how does this look in practice? Let’s return to the example of the borrower whose debts total $500 per month on a $5,000 gross salary. To keep the borrower’s debt-to-income ratio below 36 percent, or $1,800 ($5,000 * 0.36 = $1,800), a mortgage lender might approve a mortgage amount that results in monthly payments no greater than $1,300 ($1,800 – $500 = $1,300). The total amount of the mortgage loan itself would depend on additional criteria such as the interest rate, the down payment, and the term length.
Debt-to-income Ratios are Only One Factor in Determining a Mortgage Eligibility
Debt-to-income ratios are used to promote greater financial stability and prevent prospective homebuyers from purchasing properties outside of their budget.
However, it is only one of many factors that mortgage lenders use when evaluating a borrower. Other factors include credit scores, work history, and the size of the down payment. Visit our mortgages page to learn more about solutions and resources for the homebuying process.