The two calculations lenders look at to assess the risk of issuing you a loan.
What is Debt-to-Income (DTI) Ratio?
The debt-to-income (DTI) ratio is the percentage of your gross monthly income to your monthly debt. It’s a way to measure your ability to manage payments, and a common measure used by lenders to assess their risk in lending you money, and ultimately whether or not to issue you a loan. Lenders want to make sure you have enough steady income (from employment, rental income, dividends, etc.) to comfortably cover your financial obligations once you have a mortgage to pay.
Factors to Consider When Calculating DTI
Your DTI factors in your gross monthly income and your monthly payment obligations. First, list all of your fixed monthly obligations:
- Rent or house payment
- Student loan payments
- Auto/Car loan payments
- Credit card payments
- Alimony or child support payments you pay
Do not include variable expenses such as groceries, utilities, gas, and taxes.
Then, calculate your recurring monthly income, including
- Wages & Salaries
- Tips & Bonuses
- Social Security
- Alimony or child support payments you receive
Flynn and Wilma Stone are interested in purchasing a home in New City, NY.
Gross Monthly Income
Flynn Stone: $7,000
Rental income from the basement apartment: $1,000
Monthly Debt Payments
Proposed housing payment (Mortgage, interest, taxes & insurance): $3,500
Credit card payments: $100
Student loan payments: $300
Car payments: $500
Debt-to-Income (DTI) Ratio
Gross monthly income: $7,000 + $6,000 + $1,000 = $14,000
Monthly debt payments: $3,500 + $100 + $300 + $500 = $4,400
DTI calculation: 4,400 / 14,000 = 0.3143 x 100 = 31.43% DTI
This DTI of 31.43% is great for prospective home buyers. Typically, the lower your DTI, the more negotiation power you possess and the more loan options you’ll have.
DTI and Your Mortgage Application
Traditionally, many lenders used the 28/36 rule when evaluating your “capacity,” one of the 4 C’s for your mortgage application. According to this rule, a household should spend a maximum of 28% of its gross monthly income on housing expenses and no more than 36% on total debt service… the DTI ratio we just figured. Nowadays, however, you can have a DTI as high as 43% and still negotiate for a home loan, though the higher your DTI, the riskier you’ll be as a borrower.
Keep In Mind
From opening an application until closing, it’s critical to avoid taking on new loans (e.g., personal, car/auto, etc.), as it can change your eligibility. Don’t celebrate your pre-approval for a loan by financing a new Mercedes! When you apply for new loans, it affects your monthly debt payments, hence, increases your DTI – sometimes knocking you out of an advantageous loan.