What Is Your Debt to Income Ratio: Where to Start?

What Is Your Debt to Income Ratio: Where to Start?

When it comes to borrowing money, many banks and lenders look at more than just credit scores and income. They also look at your debt to income ratio, which helps to give them a better indication of your ability to pay back the loan. If you are not familiar with the term, it might be good to take a look at what it is and how to calculate your own.

Related Blog: What Factors Are Included In Your Monthly Mortgage Payments?

What is a Debt to Income Ratio?

In the simplest terms, a debt to income ratio compares the total amount you earn each month to the amount you owe. Even though your debt to income ratio (DTI) never appears on a credit report, it is nonetheless a valuable tool for the lender to use.

It should be easy to see why lenders use DTI. You could have a substantial income, but if your monthly outgoing is the majority (or more, in some cases) of what you earn, you could find it difficult to take on another payment.

The lower your DTI, the more likely you will be able to repay a loan. But as your DTI increases, you will find it more challenging to make ends meet.

As you can see, having a lower DTI not only helps the lender, but it can also be an excellent tool to judge how significant your margins of financial safety are. This is why it's a good idea to keep your DTI low, even if you aren't in the market for a new loan.

Different Types of Debt to Income Ratio

There are generally two types of DTI that most lenders consider - front-end and back-end.

Front-end DTI is focused on how much of your monthly income goes towards housing. This would include such things as mortgage payment, home insurance, and property taxes. Many lenders will look only at front-end DTI to make a decision.

Back-end DTI takes into account all of your debts as compared to your monthly income. This would include such things as credit card payments, vehicle loans, student loans, and all other types of monthly debt.

What Should Your Debt to Income Ratio Be?

As we have stated, the lower your DTI, the better off you are. But lenders tend to look for a specific DTI range before they loan money. For most mortgages, lenders like to see a backend DTI of 43% or less. If they look only at front-end DTI, you should have one below 28%

Other types of loans (and some lenders) can be more aggressive about your DTI. In a lot of cases, a back-end DTI below 36% is required to do business.

How to Calculate Your Debt to Income Ratio

It's not hard to calculate your DTI. First, add up all of your monthly recurring debt. This will include anything that is paid on a monthly basis. For items that some of you may handle yearly (such as property taxes), you should divide that total by 12 and add it to your total.

Once you have your total, divide this number by your total gross income for the month, and then multiply by 100%. Note that we are talking about gross income before any taxes or withholdings are subtracted. This calculation will give you your DTI.

For example, let's say that Jill has $2500 in total recurring debt every month. This includes a modest house payment and credit card bills. Jill makes $5000 a month before taxes and withholding. Her backend DTI is (5000 / 2500) * 100%, or 50%, which would probably be too high for a lot of lenders to consider.

Your front-end DTI is calculated in the same way, but for your debt total only add up your bills as they pertain to housing.

How to Improve Your Debt to Income Ratio

To improve your DTI, you can either reduce debt or increase your monthly income, or do both. In the case of Jill above, let's say she paid off a car that was costing her $500 a month. She also got a promotion that now pays her $5500 a month. Her new DTI is roughly 42%, which makes her finances a lot more attractive to most lenders.

At Lend Smart Mortgage, LLC, we are experts in the field of mortgages and lending. We have offices throughout the Midwest and now proudly serve those in Florida. We can help you better understand your particular situation, and have many questions already answered on our handy downloadable PDF for your convenience. But for everything else, please don't hesitate to contact us to see how we can be of service to you.

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