There are many different data points that a mortgage company will use to determine whether to extend an offer for a loan to applicants. This includes your total income as well as the source of that income, and your credit score and credit history.
Another calculation that almost all mortgage companies will consider is what's known as your debt-to-income ratio, or DTI. Lenders will use this ratio to determine how risky you are to them for a loan and, ultimately, whether they will want to extend you an offer based on it.
But, what exactly is a DTI, how is it calculated, and what range do you need to fall within to qualify for a loan? Let's dive deeper into each of those sections below.
What is a Debt-to-Income Ratio?
A debt-to-income ratio is simply a calculation that's done that shows the amount of an individual's gross income that is allocated to paying their bills. DTI is calculated on a monthly basis and is expressed as a percentage.
Mortgage lenders will use an applicant's DTI as just one measure for deciding whether to extend you a loan offer. The DTI will help the lender decide how much they want to allow you to borrow.
Other measures such as your credit score and credit history will determine your interest rate. Numbers such as the total amount of your down payment relative to the price of the home will determine what type of mortgage you'll be offered, and whether you'll have to pay extra fees such as PMI, or private mortgage insurance.
But, DTI is perhaps the most important financial measure that lenders will use in their mortgage decisions. In fact, having too high a DTI can easily lead to an applicant being denied a mortgage, no matter how good their credit score is or how much money they make.
How to Calculate DTI
DTI is calculated simply by dividing all your debt obligations by the amount of grow income you earn on a monthly basis. Your gross income is what you earn before any taxes or other benefits such as retirement contributions are taken out.
Most lenders will not consider ordinary costs such as utilities, health insurance, food and transportation as part of the debt obligations. All other debts will typically be included in the DTI calculation.
For instance, if your total monthly debt obligations are $2,000 and your gross monthly income is $10,000, your DTI will be 20% (2,000 / 10,000).
Types of DTIs
Most lenders will look at two different types of DTIs when making their lending decisions.
The first is the front-end DTI, which is simply all of your monthly expenses related to your housing divided by gross monthly income. The expenses here would include the mortgage payment you'd be taking on, as well as any HOA fees, home insurance and property taxes you'd pay.
The second type is called the back-end DTI. This adds all of your other monthly debts on top of the expenses related to housing. Because this includes more types of debt, the back-end DTI is always higher than the front-end DTI.
Mortgage lenders may consider both DTIs, but the back-end typically will matter more, since it will consider all of your monthly debt obligations.
What DTI Do I Need to Qualify for a Loan?
Generally speaking, mortgage lenders will want to see a front-end DTI that is 28% or less, as well as a back-end DTI that is 36% or less. In other words, lenders typically don't want all of your debts to be more than 36% of your gross monthly income, with no more than 28% going toward your housing expenses.
This means that, in some cases, a lender may frown on a prospective homeowner applying for a mortgage that would result in them having a front-end DTI of 33%, for example, even if they have no other debt. The reasoning for this is that lenders will assume that even people who don't have non-housing related debt now will likely take some on in the future.
That being said, every lender will operate a little differently and could have slightly different ranges for acceptable DTI. Some lenders will accept a DTI as high as 43% from an applicant, though that applicant may have to opt for a mortgage that is backed by the government, such as a VA, USDA or FHA loan.
What are the Different Ranges of DTI?
DTI is only one of the measures that lenders take into consideration when making loan offers. If your DTI is in an excellent range, the lenders will simply move onto the next metric to determine what your interest rate might be.
But, if your DTI is not in an ideal range, it doesn't automatically mean you won't qualify for a mortgage.
Typically speaking, if you have a front-end DTI that's less than 28% and a back-end DTI that's less than 36%, you'll be considered in good standing. This essentially means that you're in a manageable position with your debt, and that you have money left over each month after all your bills are paid.
A back-end ratio greater than 36% but less than 50% could be adequate, depending on other factors and the specific lender. If your DTI falls in this range, you may need to meet some other requirements to be considered eligible for a loan.
If your DTI is 50% or greater, you likely will not be approved for a mortgage. A ratio this high generally suggests that you don't have enough money leftover on a monthly basis after your bills are paid to be able to pay for an unexpected event. It also means you likely are in a position that you won't have many options to borrow money to pay for such an event.
DTI is a general calculation that gives lenders a quick and telling overview of your entire financial situation. While it's not the be-all, end-all of making a lending decision, it will go a long way in determining whether you are approved for a loan -- or what you might have to do in order to be approved in the future.
You should always look to have the lowest DTI as possible, which can be achieved by paying down existing debt, purchasing a less expensive home, earning more money or some combination of those three things.