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Debt to Income Ratios Explained

February 6, 2023 By: Great Midwest Bank

We’ve talked before about how your credit score is a key part of the process when securing a Home Mortgage Loan. Credit score, though important, is not the only factor lenders consider when you’re applying for a mortgage. Your debt-to-income (DTI) ratio also plays a major role in the lending decision. Lenders consider it a strong indicator of your financial health and creditworthiness.

If this all sounds intimidating, don’t worry. We’ll cover what you need to know about DTI when pursuing a loan.

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What is a debt-to-income ratio?

On a basic level your debt-to-income (DTI) ratio compares how much money you owe versus what you earn each month. It is determined by dividing your total monthly debts by your total monthly income.

Someone with a high debt-to-income ratio spends a high percentage of their monthly earnings to cover debts. The higher someone’s DTI, the more potential risk they present as a borrower. That’s because they likely have less wiggle room in their finances and could potentially have a more difficult time making additional loan payments on top of their current monthly debts.

Lenders like to see lower debt-to-income ratios because it indicates the borrower has more funds available every month to put toward loan payments. Therefore, the individual will be more likely to make payments in a timely manner.

Front-end Versus Back-end DTI

There are also different classifications of debt-to-income (DTI): front-end and back-end. Your future monthly mortgage payments are considered front-end, along with yearly taxes and homeowners association fees.

Back-end DTI includes your future housing expenses plus all your current other monthly debts, such as car payments, credit card dues, student loans and other loans.

Of the two types of DTI, back-end DTI tends to be examined more closely in lending decisions. This is because it gives a full picture of your monthly expenses — what your mortgage payments will be plus all your other regular dues. Front-end DTI is still typically measured by lenders as well because it isolates how much of your income will go solely toward your mortgage payments. It is another piece of information in your financial portrait, and many lenders have a preferred front-end DTI range in mind when considering a loan.

How to Calculate Your Debt-to-Income Ratio

Before pursuing a loan, you may want to get a better idea of where your debt-to-income (DTI) stands.

Note that your DTI may be calculated a little differently if you currently own a home and want to make an offer that doesn’t stipulate the requirement of selling your current home (a “non-contingent” offer). In this case, you may have to qualify with both current and proposed housing payments included in your DTI ratio. The reason for this is that there would likely be a period of time in which you carry a mortgage for your current home and your new home at the same time — so both would need to be factored into your DTI.

As mentioned, the basic calculation is monthly debts divided by total monthly income. Here’s how that all breaks down so you can calculate your debt-to-income ratio.

1. Add together monthly payments.

First, document all your monthly payments. Only count recurring payments and factor in the minimum payment amount (even if you pay more than the minimum). If there will be other people listed on the loan besides you, their debts should be added in as well. Add up any of these monthly expenses you have:

  • Proposed new monthly mortgage payments (include 1/12th of annual insurance and real estate taxes)
  • Credit card payments
  • Car loans
  • Student loans (1% of the balance if they are not yet in repayment)
  • Child support and/or alimony payments
  • Other loans
  • Other monthly obligations

These expenses should NOT be included:

  • Current mortgage or rent payments (exception: if you currently own a home and plan to make a non-contingent offer)
  • Utilities, phone or cable expenses
  • Premiums for health-related insurances
  • IRA or 401(k) contributions
  • Transportation expenses
  • Day-to-day expenses like food, clothes and recreation

2. Divide monthly payments by income.

Determine how much gross income (pre-tax) you bring in per month. As before, if there will be multiple borrowers on the loan you should include their income in the calculation too.

To calculate your DTI ratio, divide the sum of your monthly debts by your total gross monthly income. This number will be a decimal. Convert it to a percentage by multiplying it by 100.

As an example, let’s say your monthly debt is $1,000 and your monthly income is $4,000. 1,000 divided by 4,000 is .25, and if you multiply that by 100 you get 25. So, your DTI, in this case, is 25%.

What is considered a “good” debt-to-income ratio?

While numbers will vary, some lenders allow for total debts of up to 45% of your gross income. Other lenders require debt-to-income (DTI) to be lower than 35%, however. Across the board, though, low DTIs and high credit scores will make qualifying for a loan much easier.

Occasionally, local lenders like Great Midwest Bank may make some exceptions when the prospective borrower shows certain “compensating factors.” A compensating factor is something that demonstrates financial strength for a borrower and can be taken into account to potentially balance out a negative like a high DTI. This may include having:

  • Cash reserves available that could cover several mortgage payments in the event of a financial strain (such as losing one’s job)
  • Sources of less standard income, beyond what was used to qualify for the loan (e.g., seasonal work, overtime payments, bonuses)
  • Debt that is exclusively or nearly exclusively related to housing — that is, having minimal or no student loans, car payments, credit card balances, etc.
  • Documentation that shows your new mortgage payments will be lower than or comparable to your current mortgage or rent payments

At Great Midwest Bank we use a common sense lending approach to take a look at your entire financial picture and options; sometimes that means setting up a flexible Portfolio Loan that remains serviced with us in Wisconsin. While we cannot guarantee everyone will qualify for a Portfolio Loan, we will explore all possible loan products for your unique needs.

Unsure about your loan options? One of our experienced loan officers can offer more insight for your particular circumstances.

How can I reduce my debt-to-income ratio?

To lower your debt-to-income ratio you will have to work to reduce your debt and/or raise your income. Here are a few things you can do to work on lowering your debt-to-income (DTI).

1. Raise your income.

While it may sound obvious, one way to lower your DTI is to find ways to bring in more income. This could include landing a better-paying job role, taking on extra hours of work, securing a second job, or doing some freelancing. Keep in mind that not all forms of income count in the DTI calculation. For self-employment, bonuses or commission income to be included, we’ll often consider a two-year average.

2. Pay off smaller debts.

One of the most practical ways to reduce DTI is to work on lowering — or if possible, eliminating — some of your existing debts. If you’re close to finally paying off your car loan, for example, see what you can do to make those last payments and close out those debts. Paying off smaller debts can make a significant difference in reducing your DTI. Also, avoid taking on additional debts at this time, such as opening new credit cards or loans.

Strategies like paying more than your minimum monthly payment, making weekly payments and loan consolidation can help you get ahead of your debt and pay it down more quickly. Making smart savings choices may also help free up some money in your budget to make larger monthly payments.

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3. Add a co-borrower to your loan application.

Perhaps you’re buying a home with your spouse or partner. Let’s suppose that your DTI is on the higher side and your significant other’s is lower. Adding them onto the loan as a co-borrower can help balance out the combined DTI. Note that if the co-borrower’s DTI is similar to or higher than yours having a co-borrower will probably not help reduce the DTI.

Have more questions on DTI? We’re here to help!

Have more questions about debt-to-income ratios (or credit scores, loan products, you name it)? We know there is a lot to think about when pursuing a loan. The good news is that you don’t need to go it alone — nor should you! Contact us and speak with one of our friendly, experienced loan officers at your local Great Midwest Bank. We’re here to help you experience a state of Bankquility!

A version of this article was originally published in July 2016. It was most recently updated in February 2023.