How Can I Lower My Debt-to-Income Ratio?
You'd like to buy a house and say ta-ta to your landlord—but you worry the stack of bills that shows up every month is standing between you and a mortgage.
Find out where you stand. Pull up the calculator app on your phone and measure your mortgage worthiness by figuring out your debt-to-income ratio (DTI). It's a metric that's almost as important as your credit score in determining whether lenders will let you borrow money.
Your DTI for a mortgage shows how much of your income is being eaten up by your loans, mortgage and credit card payments each month. Just like your credit score, lenders look at your DTI to rate your financial health. Here's how to wrangle it in your favor:
Calculating your debt-to-income ratio (DTI) for a home loan
Figure out your DTI by adding up the total of all of your monthly debt payments—like credit cards, car payments, house payment or student loans—and dividing them by your gross (pretax) monthly income. You'll get a number that's a percentage of how much of what you earn goes to you your bills each month.
So let's say your pretax income is $5,000 a month and you pay a total of $2,000 in car payments, student loans and rent. That puts your debt-to-income ratio for a home loan at 40 percent. That's monthly gross income ÷ monthly debt payments. Don't include utility bills, contributions to your 401K or grocery bills. They're not debt, so they don't count toward the DTI.1
What's a good DTI?
A debt-to-income ratio of 43 percent or lower is a good target when you for a mortgage. Research shows that people with DTIs above 43% will have more difficulty paying off monthly mortgage payments. That's because if a big chunk of your monthly paycheck is going towards bills, you'll have less money to cover unexpected expenses and still make the mortgage. Think of your DTI as a measure of how much cushion you have in your budget.3
A DTI of 20 percent is low and therefore, considered excellent by lenders evaluating your ability to take on a mortgage. Mortgage lenders will love you. A DTI of 50 percent or higher is bad and, according to the Federal Reserve, a sign of financial distress. Having a low DTI for a mortgage will get you lower mortgage interest rates and more flexible payment terms because lenders are confident you'll pay back your loan. A higher DTI means that lending you money is riskier, so lenders will charge you higher interest rates—or they may not approve a mortgage at all.3
5 savvy ways to lower your DTI2
So let's say your DTI is 50 percent. You earn $6,000 a month pre-tax but pay $3,000 a month for a car payment, credit card, and a personal loan. To lower your DTI to a more desirable number so you can buy a house, you need to: a) make more money, or b) pay off some of your debt. Here are some ways to do one or the other:
1. Pay off your loans ahead of schedule
Most installment loans, like car payments or student loans, have a repayment plan that runs for years with a fixed payment every month. You don't have to stick with the repayment plan. Make extra payments and pay off the loan early. Of course, you'll have to find room in your budget for the extra payments. Figure out what you can live without (hello, daily mocha lattes and your subscription dinner habit) and use that money to whittle down your debt.
Some loans have minimum payments that are a higher percentage of their balance than others
2. Target debt with the highest bill-to-balance ratio
Not all debt is equal. Some loans have minimum payments that are a higher percentage of their balance than others, and you should pay them off first. Let's say you owe $350 per month on a credit card with a $1,000 balance, and $350 a month on a student loan with an $8,000 balance. Pay off the $1,000 credit card bill first, because its monthly payment is a third of its balance. Paying it off will have a bigger impact on your debt-to-income ratio for a home loan than paying off the student loan with a monthly payment that's just 4 percent of its balance.
3. Increase your income
Negotiate for a raise or promotion at your current job, get a new job that pays you more or earn extra money with a side gig. Say you make $5,000 a month at your current job and have $2,500 in debt payments, giving you an undesirable DTI of 50 percent. If you can wrangle $1,500 more income a month, your DTI drops to 38 perform. Boom.
4. Use a balance transfer to pay down debt
Lower your monthly debt payments by moving your debt to a credit card that's offering 0% APR for a promotional period. The break you get from interest can help you pay off the balance faster. Look out for balance transfer fees, though, and be sure you pay off the debt before the promotional period ends.
5. Refinance your debt with a new lender
If you cannot afford to pay off student or car loans early, refinance them so that you lower your monthly payments. If you've racked up a lot of credit card debt and are swimming in minimum monthly payments, get a loan to consolidate the balances so you can make one low monthly minimum payment that takes a smaller bite out of your income.
DTI math: The fun is in solving the problems
To calculate your DTI ratio, use a mortgage DTI calculator to add up the following recurring monthly payments:
- Mortgage or rent payment
- Car loan or lease payment
- Minimum credit card payment
- Minimum student loan payment
- Minimum payment on personal loans
- Child support or other regular debt payments
Divide the total by your gross monthly income. The gross is the amount you earn before taxes. Most of us can find that number on our paystub. If you're applying for a mortgage with another person, add their gross income, too, to get a household total.
Multiply it by 100 to turn it into a percentage. Presto. That's your DTI.4
A front-to-back understanding of DTI ratios
There are two other measures of your financial fitness mortgage lenders look at.
1. Getting the grasp of front-end DTI ratios
This includes only your housing related expenses. It's also called the Principal, Interest, Taxes and Insurance Ratio (PITI), and it measures your total monthly housing costs as a percentage of your gross income. Here's the formula:6
(Monthly mortgage principal + loan interest + property taxes + property insurance premiums) ÷ monthly gross income = PITI.
Note: Lenders also include escrow payments, HOA dues, and any other special assessments related to being a homeowner.
Most lenders prefer a borrower's PITI to be no higher than 29 percent of your monthly income.
2. Understanding the back-end DTI ratio
This includes all your monthly expenses, everything from the mortgage or rent to the VISA payment. Also called the Total Debt Ratio, it's calculated this way:5
PITI+ (loan payments ranging from credit cards to cars to student loans to alimony + personal loans) / monthly gross income = TD.
Most lenders prefer a borrower's TD to be lower than 43 percent of your monthly income.
You've learned the ABCs of DTIs and PITIs and you know how to use a mortgage DTI calculator. Now you can get work on lowering that number so you can build wealth as a homeowner instead of sending most of your money to creditors and your landlord.