Lenders don’t just use FICO and credit scores to assess whether to approve an application for a mortgage or home loan. The debt to income ratio of the borrower plays a key part in establishing whether they are creditworthy or not. What is a debt to income ratio, why is it important and how can consumers calculate their own ratio?
What is a Debt to Income (DTI) Ratio?
This ratio is basically a statistic that shows the percentage of debt compared to income. An individual’s ratio is a way of giving a standardized snapshot view of how much debt they owe compared with how much money they earn. This figure is commonly used by lenders as part of the mortgage approval process.
Why is the DTI Ratio Important to Mortgage Lenders?
Lenders use a variety of measures to assess the creditworthiness of mortgage applicants. They may, for example, check their FICO score to see how they have managed money in the past. The debt to income ratio gives them an important alternative view of a borrower’s finances.
Those applying for a mortgage need to prove to the lender that they are not borrowing more than they can afford to pay back. Their DTI ratio gives an easy to understand percentage score that shows debt commitments in comparison to disposable income.
Each lender will have their own acceptable and unacceptable ratio levels. If an individual’s ratio is higher than the lender would like then they may turn down their application or charge higher rates; if the ratio falls within their limits then the individual may pass this part of the application process.
What is the Difference Between Front-End and Back-End Debt to Income Ratios?
There are two possible types of debt to income ratio that may be used. These are:
- Front-end: This ratio is based on housing costs/debts.
- Back-end: This ratio is based on total debts.
The front-end calculation is a little simpler as fewer elements are involved.
How to Calculate a Debt to Income Ratio
To calculate a simple front-end debt to income figure the individual needs to work out all of their housing costs (i.e. monthly mortgage payments, taxes and home insurance). This is then divided by gross monthly income. So, for example, an individual that earns $3,000 a month and that has housing expenses of $800 a month would have a debt to income ratio of 27%.
Figuring a back end DTI ratio involves adding in other debts (i.e. loans, credit cards, student loans) as well as housing expenses. Here, if the individual is still earning $3,000 a month but has total monthly debt commitments of $1200 then their ratio would increase to 40%. Those that prefer not to make their own calculation may find it easier to use an online debt to income ratio calculator.
How to Improve Debt to Income Percentages
Those whose DTI ratio is on the high side may want to consider ways to bring it down. This won’t just help them borrow money in the future but may help them keep their finances under control in general terms. Options worth considering include:
- Switching credit card debts to a zero percent balance transfer card to repay them quicker.
- Consolidating multiple loans if this will reduce monthly repayments and overall costs.
- Making a financial health check to find ways to save money/increase spare cash that can go towards debt repayment.
Looking to pay down debt to improve a less than perfect debt to income ratio may take some time but could be very useful in the long term.