When you decide to buy a home, you may peruse property listings online and even schedule a few showings. After all, these are the exciting parts of the home-buying process. But before you get your heart set on your dream home, it’s important to evaluate your mortgage eligibility first.
Mortgage lenders consider many eligibility factors during the underwriting process. One of the most influential factors is your debt-to-income (DTI) ratio. So, what is a DTI ratio? And how exactly does it affect your chances of getting approved?
In this article, we’ll define DTI and explain its impact on mortgage approval. We’ll also provide some actionable tips for optimizing your DTI before you submit your mortgage application.
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What is a DTI Ratio?
Your DTI ratio is the percentage of your gross monthly income that’s allocated to monthly debt payments. This metric gives lenders an idea of how much more debt you can take on without overextending yourself financially.
To calculate your DTI, all you have to do is add up your monthly debt payments and divide the resulting number by your gross monthly income (your income before taxes). After that, multiply that number by 100% to transform it into a percentage.
A low DTI ratio indicates that you have room in your budget for additional debt payments. Meanwhile, a high DTI suggests that more debt may become an undue burden on your budget, putting you at risk of falling behind on loan payments.
Front-End DTI vs. Back-End DTI
Mortgage lenders look at two different types of DTI ratios during the application process. These DTIs are as follows:
- Front-end DTI – Your front-end DTI ratio only looks at your prospective housing-related expenses, including your monthly mortgage payment, property taxes, homeowner’s insurance, private mortgage insurance (PMI), and homeowner association fees, if applicable. Your front-end DTI helps lenders evaluate if your income is high enough to comfortably cover these housing expenses if you get approved for your mortgage.
- Back-end DTI – Back-end DTI factors in all of your monthly debt obligations. Along with housing-related expenses, it includes any monthly payments that go toward your credit cards, lines of credit, student loans, auto loans, personal loans, leases, alimony, and child support. As such, your back-end DTI ratio offers a more comprehensive picture of your financial situation. Mortgage lenders can use it to predict your risk of default if they grant your mortgage request.
DTI Ratio Calculation Example
To clarify DTI, let’s look at a simple example: James is a first-time homebuyer with a gross monthly income of $5,000. He reviews his finances and lists out his monthly debt obligations.
This debt list includes:
- $1,000 for his prospective monthly mortgage payment
- $500 for his auto loan payment
- $100 for his first credit card’s minimum monthly payment
- $50 for his second credit card’s minimum monthly payment
He adds these debt obligations and discovers his monthly debt is $1,750. After dividing $1,750 by $5,000, James learns that his DTI ratio is 0.35, or 35% when expressed as a percentage.
What is a “Good DTI” For a Mortgage?
Now that you know how to calculate DTI, you may be wondering what percentage you should aim for if you want to secure a mortgage approval. The lower your DTI, the better. Most mortgage lenders prefer applicants who have front-end DTI ratios of 28% or below and back-end DTIs of 36% or below. Even so, DTI requirements can vary from one loan program to the next.
Here’s an overview of the maximum acceptable DTI ratios for the following mortgage programs:
- Conventional loans – Conventional loan DTI requirements can vary from lender to lender, though you’ll almost always need a DTI below 50% to qualify. Most lenders won’t approve conventional loan applicants with DTIs above 45%.
- FHA loans – Loans backed by the U.S. Federal Housing Administration (FHA) have more lenient DTI requirements. The maximum DTI you can have to qualify for an FHA loan is 57%. However, mortgage lenders who offer FHA loans are allowed to set lower requirements.
- USDA loans – Loans backed by the U.S. Department of Agriculture can only be used to buy or refinance homes in eligible rural areas. They also have certain household income requirements. To qualify for a USDA loan, your DTI must be 41% or below.
- VA loans – Loans insured by the Department of Veterans Affairs are reserved for current and former members of the Armed Forces, along with their surviving spouses. VA loans allow for DTIs of up to 60%, though lenders can set their own requirements.
How to Lower Your DTI Ratio
If your DTI ratio exceeds your chosen loan program’s acceptable limits, you may want to pause your home search and work on decreasing your DTI ratio before you apply for a mortgage.
Here are a few ways to lower your DTI ratio quickly:
- Pay down your monthly debts – The fastest way to lower your DTI is to reduce your monthly debts. For instance, you can pay down your credit card balances or pay off some loans before submitting your mortgage application. This strategy can lower your DTI quickly—as soon as the debt is paid down, your DTI ratio will decrease.
If you have a lot of debt, consider using the avalanche method. With this method, you pay down your debts in order of their interest rates, starting with the highest interest rate debt first. By tackling your debts with high-interest rates, you can get out of debt faster and reduce your monthly debt obligations as efficiently as possible. - Transfer high-interest credit card debt to a low-interest credit card – A large portion of your minimum monthly credit card payment is interest. If you can transfer your debt to a lower-interest-rate credit card, you may be able to reduce your debt payments (and DTI ratio) without paying down your outstanding balance.
- Restructure your loans — As with credit cards, you may be able to refinance or consolidate your loans to reduce their interest rates, monthly payments, or both. Doing so can lower your DTI.
- Apply with a co-signer — A co-signer is someone who adds their name to your mortgage application to help you qualify. If you plan to purchase your home with a spouse, they can serve as a co-borrower. However, you can also ask a parent or another loved one to co-sign your mortgage. If your chosen co-signer has a low DTI, they may be able to reduce your application’s overall DTI enough to secure you a mortgage approval.
Another way you can reduce your DTI is to increase your gross monthly income. You can do so by applying for a job with a higher salary, requesting a raise, or starting a side business. Just keep in mind that most lenders ask for two years of documented income to use in their DTI calculation. Thus, recent surges in income won’t necessarily factor into your DTI right away.
What Other Factors Affect Mortgage Approval?
While your DTI ratio is a highly influential factor when it comes to mortgage approval, it’s not the only one. Mortgage lenders also care about your:
- Credit score – Typically, you need a credit score of 620 or higher to qualify for a mortgage, though some loan programs have more lenient requirements. If you apply with an excellent credit score (800 or above), you are more likely to qualify for a lower interest rate.
- Down payment – Your down payment is the percentage of your home’s purchase price that you pay upfront. A large down payment can reduce your loan-to-value (LTV) ratio. Loans with lower LTVs are less risky for lenders, and therefore, often easier to qualify for. They may also come with lower interest rates.
What’s more, borrowers who make down payments of 20% or more aren’t required to purchase private mortgage insurance (PMI). As with scoring a low-interest rate, eliminating PMI may reduce your monthly housing expenses and resulting DTI. - Employment history – Most lenders prefer to approve mortgages for applicants who possess stable employment histories. A steady, salaried job that generates a consistent income is typically considered more stable than a string of side gigs with volatile earnings.
- Assets – Having large cash reserves, savings, and investments can also bolster your financial stability in lenders’ eyes. Lenders view these assets as a safety net—if you can’t afford your monthly mortgage payments on your income alone, you can use these assets instead.
If these eligibility factors are in great shape, your lender may be willing to overlook a slightly elevated DTI.
Enhance Your Mortgage Eligibility With Certified Credit
As you can see, your DTI ratio is a crucial factor to optimize before applying for a mortgage. If you want to learn more about mortgage eligibility and the home-buying process, check out the Certified Credit blog. There, we share many educational articles and helpful resources for aspiring homebuyers.
If you’re a mortgage lender, feel free to share these resources with your applicants. You can also check out our products and services for mortgage lenders. As a leading mortgage solutions provider, we offer everything from automated loan manufacturing tools to affordable credit reports.
