Your debt-to-income (DTI) ratio is an important number in the mortgage world. This short article will go over a few basics including what it is, why it’s important and how you can improve your DTI quickly.
What is Your Debt-to-Income Ratio?
Your DTI is one way lenders are able to estimate if you can pay your mortgage. It is calculated by dividing your monthly debt payments by your gross monthly income.
For example, let’s say you have the following debts:
- $300 car payment
- $400 student loan payment
- $1,700 mortgage
In that case, your total monthly debt is $2,400.
Now, if you make $78,000 per year, or $6,500 per month, that’s your gross income used in the calculation.
That makes your DTI = $2,400/$6,500 = 36.9%. That number is okay, but ideally lenders would like for that number to be lower.
Why is Debt-to-Income Ratio Important?
Your DTI is a way for lenders to see how much of your income is going towards recurring debt. The higher that percentage, the less money you have to pay for other aspects of life.
Keep in mind that DTI is using your gross income, not net. That means your taxes haven’t been taken out yet.
Assuming you pay about 33% in taxes, that drops your $6,500 per month down to $4,355. We already said that $2,400 of that is allocated to your debts, meaning you now have $1,955 left each month.
Sound like a lot? Remember, that’s all the money you have left to pay for everything else:
- Insurance (car/medical/home/etc.)
- Gas for the car
- Car maintenance and repairs
- Home maintenance and repairs
- Random stuff for around the home
- Childcare (if applicable)
This is assuming you aren’t saving any of the income. If you do save regularly, maybe 10%, that means another $650 of that $1,955 now isn’t available.
As we mentioned earlier, a DTI around 37% isn’t too bad, but what if someone had a DTI of around 45%? That means of the $6,500 they make, $2,925 is taken up by debts alone. Once you remove taxes, they’re left with just $1,430 to live on.
How Do You Improve Your DTI Ratio?
There are two ways to improve your DTI: pay off debt and make more money. When it comes to the best way to improve your DTI, paying off your debt will have a greater impact.
For example, let’s say you have 2 options: you can choose to pay off your $300 car payment, or you can make $300 more each month.
By paying off your car payment, your DTI changes to $2,100/$6,500 = 32.3%. Nice!
If you make $300 more per month but still have a car payment, you’re at $2,400/$6,800 = 35.3%. Better, but not as good.
Ideally you can do both. You make extra money, then use it to pay off your debts faster. Win-win.
Do you have any questions about your debt-to-income ratio? Send me an email at firstname.lastname@example.org and I’ll be in touch soon!