#24 - What is Debt-to-income Ratio and to Use it When Purchasing or Refinancing a New Home

Updated: Jun 11, 2021

-What is debt-to-income ratio (DTI)? -How do I calculate DTI? -What is the acceptable level that lenders will provide loans? -What is the impact in that DTI only calcualtes gross monthly income?

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

So here is what the lender does: they take all your major debts such as a current mortgage, student loans, auto loans, child support, credit card payments any entity that has established debt with.

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