Your debt-to-income ratio is an easy but important calculation.
When getting financially prepared to apply for their first mortgage, people tend to focus on one thing: their credit. And it’s true that building good credit is an important part of scoring a great mortgage — but it’s not the whole story. Having a good debt-to-income ratio is a big deal, too. Here’s what it is and what a good debt-to-income ratio looks like.
Simply put, a debt-to-income ratio (or DTI ratio) is a number that represents how much debt you have relative to your income. Specifically, it is your monthly debt payments divided by your gross (pre-tax) monthly income.
Your mortgage lender uses this number to decide how risky a borrower you’re likely to be. The lower your debt-to-income ratio (and the better your credit is) the easier it will be to get pre-approved for a mortgage.
Once you’ve determined your debt-to-income ratio comes the obvious question: Is mine any good? Generally speaking, 36 percent or less is considered an ideal debt-to-income ratio. Have 20 percent or less? You’re a debt-to-income rockstar.
But you don’t need an ideal number to get a mortgage. On the other end of the spectrum, 50 percent is the highest debt-to-income ratio many lenders will consider. And if you want a qualified mortgage, you’ll need a debt-to-income ratio of no more than 43 percent.
If your debt-to-income ratio is between 50 and 43 percent, it could be worthwhile to pay down your debt (or increase your income) before applying for a home loan, because not all mortgages are the same.
A qualified mortgage comes with protections that make it less risky for you, like prohibiting balloon payments and interest-only periods. But everyone has to decide what type of mortgage is best for their financial situation. Just like some people decide to pay private mortgage insurance, or PMI, rather than wait until they have a full 20 percent down payment, you could decide to get an unqualified mortgage because your financial situation can handle it.
If you have calculated everything and are unhappy with your current ratio, or you think it could be a tad better, don’t panic. There are three ways to move the needle in your favor, though they aren’t surprising: lower your debt, raise your income — or both. When getting financially prepared to apply for a mortgage, both are a smart idea anyway. With any luck, you’ll soon need the extra room in your budget to make your mortgage payment.