What is Debt-to-income Ratio?
DTI is the personal finance measure that compares the amount of debt correlated to your overall income. So when lenders are looking at you as a qualified buyer, DTI is used as a way to measure your ability to manage payments that you make each month.
When you hear about the DTI ratio, it is more specifically geared toward buying a home in most cases. When you're creating your budget, paying off debts and making smart savings plans can all contribute to improving your DTI ratio overtime.
So when lenders review this measure, they're not looking at all the other factors in your life. It is simply tied to the potential a consumer loan or mortgage payment.
So the goal in obtaining approval for a loan is to understand how to calculate your DTI. It is actually an easy exercise and when you calculate the ratio, it’s no different than what the lender does when they evaluate you.
How to Calculate DTI
The calculation is as follows: take your debt amount that is owed each month and divide that by your gross monthly income each month. Hence, it's your monthly bills divided by your gross monthly income.
Let’s perform a hypothetical scenario: Assume you have a $1,200 mortgage payment. $400 for a car and $400 for the rest of your debts each month.
The monthly debt payments would be as follows: $2,000 in monthly bill debt, Now assume that you have $6,000 in monthly gross income. The next step is to divide $2,000 by $6,000 and this comes to a 33% DTI.
Let’s say that your monthly income is $5,000. The percentage would be 40%. ($2,000 / $5,000)
What is an Acceptable DTI?
As this is predominantly a mortgage-based scenario, a lender wants to see a DTI that is under 36% and the threshold is around 43%, with no more than 28% of that debt going towards your mortgage. For example, let's say you wanted to buy a house and your income is $4,000 a month. The maximum monthly mortgage related payments you have at 28%, would be a mortgage payment of $1,120.
So you can figure out this number before you consider buying a house. The other factor is that if you are granted approval to obtain a mortgage with a high percetnage, chances are that you will have to pay a higher interest rate. Not to mention the other factor that plays into this which is the credit score. It is a simple measurement: the higher the risk, the higher the interest rate.
DTI Only Calculates Gross Income
As DTI only measures gross income (not after-tax income) and this means the lender is not factoring in all the other bills you pay for each month. Hence, this does not account for items such as groceries, auto insurance, utilities, child care, pet needs, health insurance or any other item in the monthly budget.
For example, the grocery bill is one of the top three expenses in the budget. What the borrower must do is look at the big picture to understand what the disposable income that is available each month.
This is why budgeting is paramount. The borrower's job is to determine what he or she can really afford. If this has not been done already, the first thing that you need to do is sit down and look at your bills and create a budget.
Only you know what your take-home pay is. Only you know what you have to pay in taxes each year.
How Do People Get Approvals for Large Mortgage Amounts?
Cindy and I have watched House Hunters on HGTV and we see people buying houses that are really expensive. The couples on the show tell you what they do for a living. Oftentimes, the people are young and they're typically not commanding large salaries. (In fairness, we’re assuming they don't have an inheritance)
Our analysis is that their estimated income does not correlate to afford the houses they choose. So how can they afford these houses?
One qualification to qualify for a house is that the borrower is measured on gross income and oftentimes, they can qualify from anywhere between three-and-a-half to four times the actual gross salary.
So underneath it all, if the borrower doesn’t manage the money this is where he/she can get into trouble with a big house payment. This is a very common scenario where people live for their mortgage. This also leads to refinancing or taking out home equity loans fostering additonal debt.
This is why we always wonder on the back end how homeowners obtain the qualification for loans; however, that's how the system works. Overall this often leads poor retirement planning.
In addtion, consider that the debt-to-income ratio doesn't directly affect your credit score. The reason is that credit agencies are not looking or they don't know how much money one has earned so their not able to make the calculations; however, they do review credit utilization ratio or debt-to-credit. What that does is compare all the borrower’s credit card account balances to the total amount credit which is the sum of all the credit limits for the accounts that are active.
So there’s the credit score factor discussed in the Personal Finance Tip #15; however, make sure that you have more availability in credit when considering all this in relation to the outstanding balances.
Let’s Do the Recap
Debt-to-income ratio (DTI) takes all of your expenses meaning mortgage, rent, consumer loans, alimony, student loan and other debt and that number is summed and it is divided by your gross income.
When performing the math the goal is stay 28% or under when for the mortgage payment will be. The second piece is to remain under 36% for the overall DTI.
DTI does not account for all the other expenses that you have in your life. Finish the budget and itemize everything that's going out the door versus the income that you bring in.
Add to the budgeting topic: only you know what your take-home pay is. Only you know what taxes you pay to Uncle Sam. Only you know how your budget works and if you don't have one, then how do you know if you have a gain or loss at the end of each month? Don’t get caught in the trap of buying something more than you can afford just because a lending institution gave you the money.
DTI does not affect your credit score; however, your credit score just look at your debt-to-credit ratio. Before you enter into the foray of buying a house pull your credit report to understand your personal finance situation. Work with your real estate agent to align your debt, credit and expenses.
Work to get your credit card utilization in check. When that number decreases it also may increase the credit score. Hence, this increases the chance for obtaining a favorable interest rate for your potential mortgage.