Mortgage lenders use a large variety of measures to figure out if and how much to lend you for your dream home. One of the most important and least understood is your debt-to-income ratio. In this post, we will break down what a debt-to-income ratio is, the different types of debt-to-income ratios, and how it affects the mortgage you can get.
What is a debt-to-income ratio?
A debt-to-income ratio is a set of monthly obligations (debts) divided by the amount you make per month (income). It is usually expressed as a percentage; for example, 25% debt-to-income (or DTI for short) means debt payments take up 25% of your monthly income. Here, "monthly income" is usually your gross monthly income, meaning how much you make every month before things like taxes are taken out. So if you make $120,000 a year, your monthly income would be $10,000, and a 25% debt-to-income ratio would mean those debts cost you $2,500 a month (25% x $10,000 = $2,500).
What are the different types of debt-to-income ratios?
There are two main types of debt-to-income ratios in mortgages: your "front-end" debt-to-income ratio and your "back-end" debt-to-income ratio.
Your "front-end" debt-to-income ratio uses your "monthly housing payment" as the only debt in the debt-to-income ratio equation. Your monthly housing payment is the amount that the lender projects you would have to pay every month for living in your new house. This includes your mortgage payment, homeowners association dues (if applicable), home insurance, mortgage insurance (if applicable), and more. So if you have a monthly income of $10,000 a month, and your new monthly housing payment was $2,000, you would have a front-end debt-to-income ratio of 20%.
Your "back-end" debt-to-income ratio uses all of your "qualified monthly debts" in addition to your monthly housing payment as the debts in the debt-to-income ratio equation. Here, "qualified monthly debts" is the sum of all debt payments you have to make every month after applying a bunch of special rules to them. For example, if you have a car loan with a $100 payment and a student loan with a $50 minimum payment, your monthly qualified debts would be $150.
Are there rules around which debts and incomes count?
Unfortunately, there are many special rules around which debts count and how much they count for. For example, for student loans that are in forbearance or deferment (meaning you have no monthly payment right now but will in the future), some lenders will add 1-2% of the entire loan balance to your monthly debts. These rules don't just add more to your debts; they can also take them out. For example, if you have an installment loan, like most car loans, and you have less than 12 monthly payments left on the loan, they won't add it to your monthly debts at all.
Similar to debts, there are special rules around which incomes count and for how much. For most W2 salaried incomes, you must have been at that job or in that line of work for at least one year. However, schooling in that same line of work actually counts towards that requirement as well. These rules don't just say whether an income counts but can also change how much they count for. For example, if you are self-employed and your income fluctuates a lot such that you make $10,000 most months and $5,000 in others, lenders can count that as if you made $5,000 every month - reducing your income from $120,000 a year to $60,000 a year.
As you can see, debt-to-income is a simple idea, but not simple to calculate. There are hundreds of rules around every type of debt, income, whether they count, and for how much towards your debt-to-income ratio.
How does my debt-to-income ratio affect my mortgage?
Debt-to-income is one of the primary factors driving how much a lender will lend to you - in fact, over 30% of mortgage denials happen because of debt-to-income ratio-related issues!
As we learned above, lenders calculate two debt-to-income ratios for you - your "front-end" and "back-end" debt-to-income. They will use these two ratios alongside other criteria, like how much money you have to put down and your credit profile, to see if there is a loan program you qualify for.
Different loan programs have different debt-to-income requirements. A standard FHA loan allows for a 31% front-end debt-to-income and a 43% back-end debt-to-income ratio. The lender will check if your debt-to-income ratios are below the requirements and that the other aspects of your application, like your credit, also meet the program's requirements.
Because of this process, your debt-to-income ratio is pivotal in determining which loan programs, if any, you qualify for. Additionally, because your debt-to-income ratio includes your new monthly mortgage payment, it also determines how large of a loan the lender will be willing to give you. This will decide the minimum amount you have to put down to buy your dream home, which in turn can affect your interest rate, savings, and more!
How can I calculate my debt-to-income ratio accurately?
Since your debt-to-income ratio is critical to figuring out if you qualify for a mortgage, which type of mortgage you qualify for, and how much you can borrow, accurately calculating it is vital. As we learned above, there are many rules around debt-to-income, making it difficult to calculate accurately.
Mortgage calculators often try and calculate this debt-to-income ratio for you, but they fail to apply the complex rules, often giving very wrong answers. Check out our other post to learn Why Most Mortgage Calculators Are Wrong. To get an accurate answer on your debt-to-income ratios, we recommend either working with a mortgage broker or using the Quo app.
The Quo app is a supercharged homeownership coach - it connects directly to your finances, asks all the right questions right in the app, and uses guidelines straight from lenders to figure out your real debt-to-income. It shows you exactly how to optimize your finances for home buying, how much you need to save, debts to pay down, and much more. Quo can help you throughout the entire home buying process, from saving for a downpayment to closing on your dream home.
Another way to get a more accurate accounting of your debt-to-income ratio is to apply for a mortgage with a broker or lender. By working with a lender or broker, they can gather the information needed to show you your real debt-to-income ratios as well. However, this usually includes getting a hard credit check (which can hurt your credit temporarily), lots of paperwork, and no guarantee that they will share the information with you. If you want to avoid the headache, we recommend trying out the Quo app first!