A debt-to-income ratio, otherwise known as DTI, is the percentage of a consumer’s monthly gross income that goes toward paying debt. In simple terms, a consumer’s DTI is calculated by dividing the amount of monthly debt payments by gross monthly income.
The DTI ratio is extremely important when it comes to qualifying for a mortgage, refinancing a mortgage, or calculating your FICO score. For example, assume the following:
- Monthly Debt Payments: $3,500
- Monthly income: $10,000
In the above scenario, the consumer’s DTI is 35% (monthly payments of $3,500 divided by monthly income of $10,000). Of course some debt cannot be avoided and is in fact a good thing, as it shows a consumer’s ability to meet their obligations.
The real question asked by most lenders is, “How much debt is too much?” Obtaining credit is often a function of a loan officer calculating the DTI to determine the consumer’s ability to meet new obligations. Too high a DTI can also impact the FICO score, making credit difficult and expensive to obtain.
Generally, lenders don’t look favorably upon consumers who must spend more than 36% to 38% of their monthly income on outstanding obligations. However, there’s one tricky part of the DTI you should know about: known as the Front-End and Back-End Debt-to-Income Ratios.
In the above example, if your monthly housing payment makes up $2,000 of your $3,500 in monthly liabilities, your front-end DTI ratio would be 20%, ($2,000 divided by $10,000) and your back-end DTI ratio would be 35%.
Many banks and lenders require both numbers to fall under a certain percentage, though the back-end DTI ratio is more important. If your bank had a DTI limit of 35/45, using the example from above, the front-end DTI ratio of 20% would be 15% below the 35% limit, and the back-end DTI ratio of 35% would also have 10% clearance, allowing you to qualify for the loan program or allow you to refinance, at least in terms of income.
Keep in mind that you as the borrower will have to provide supporting documentation such as a W-2 to prove the income level is as stated.
Here are some general guidelines for DTI ratios that will give you a reasonably good idea of how a loan officer would view your DTI:
- 20% or less is generally considered excellent by the vast majority of loan officers.
- 20% – 36% is a good ratio and will most likely not be a cause for concern for a loan officer or negatively impact your FICO score.
- 36% – 40% starts to make you a questionable candidate and a credit risk. Most lenders will want to understand why your DTI ratio is so high. Most likely, a DTI in this range will affect your FICO score as well.
- 40% or higher is a huge “no-no,” and your FICO score is sure to suffer. This is usually a deal breaker for the majority of lenders.
Many mortgage brokers will try to avoid “full documentation loans” if they feel the borrower’s income alone will not qualify him/her for the loan. For this reason, banks and lenders offer reduced documentation loans such as SIVA (stated income, verified assets) loans, and No Ratio (no income, verified assets) loans.
It is always wise to do “a back of the envelope” calculation as to what your DTI is. By doing so, you can understand your financial situation and whether you have too much debt or would be considered risky from a credit perspective.
If you feel that your DTI is too high, you can do one of two things: increase your income or pay down debt. A decrease in a consumer’s DTI is a good way to enhance credit history, thereby making it easier and less expensive to obtain loans.