Qualifying debt to income ratio explained

Debt-to-Income Ratio (DTI) Explained: How It Affects Your Home Loan approval and even loan type

When you're qualifying for a home loan, your credit score gets a lot of attention. But another number can be just as important—and sometimes even more important:

Your debt-to-income ratio, or DTI.

Your DTI helps determine how much mortgage payment you can qualify for based on your income and existing monthly debts.

The basic concept is simple. However, calculating DTI correctly isn't always as straightforward as it sounds because mortgage guidelines have specific rules about which income can be used and which monthly debts must be counted.

Here's what home buyers need to know.

What Is a Debt-to-Income Ratio?

Your debt-to-income ratio compares your qualifying monthly debt payments with your gross qualifying monthly income.

Gross income generally means income before taxes and other payroll deductions.

The basic formula is:

Total Monthly Debt Payments ÷ Gross Monthly Income = DTI

For example, suppose your qualifying gross income is $10,000 per month and your total monthly debts, including the proposed housing payment, equal $4,000.

$4,000 ÷ $10,000 = 40% DTI

In this example, your debt-to-income ratio is 40%.

Why DTI Is So Important When Qualifying for a Mortgage

Mortgage lenders aren't simply looking at how much money you earn.

They also need to know how much of that income is already committed to other debts.

Two borrowers could earn exactly the same income but qualify for very different loan amounts because one has significantly higher monthly debt payments.

For example, a large car payment may have a surprisingly big impact on how much mortgage you can qualify for.

That's why DTI is such an important part of determining your maximum qualifying mortgage payment and home-buying price range.

What Debts Are Included in Your DTI?

Mortgage lenders generally count recurring monthly debt obligations, including:

• Your proposed mortgage payment
• Property taxes
• Homeowners insurance
• Mortgage insurance, when applicable
• HOA dues, when applicable
• Car loans and leases
• Student loan obligations
• Minimum credit card payments
• Personal and installment loans
• Child support or alimony obligations when applicable
• Other qualifying recurring debts

The new housing expense is often referred to as PITIA:

Principal + Interest + Taxes + Insurance + Home Owners Association dues

Mortgage insurance may also be included when required.

What Expenses Usually Aren't Included?

One of the biggest misconceptions about DTI is that lenders count every expense in your household budget.

They don't.

Ordinary living expenses generally aren't included in the mortgage DTI calculation.

For example, lenders normally don't include:

• Utilities
• Cell phone bills
• Internet
• Groceries
• Gasoline
• Entertainment
• Clothing
• Most routine household expenses

This is an important distinction.

DTI is a mortgage qualifying calculation—not a complete household budget.

Just because a lender determines that you qualify for a particular payment doesn't necessarily mean that payment fits comfortably into your personal budget.

Your Housing Ratio vs. Your Total Debt Ratio

You may hear mortgage professionals refer to a front-end ratio and back-end ratio.

Housing Ratio

The housing or front-end ratio compares your proposed monthly housing expense with your gross qualifying income.

For example:

$3,000 housing expense ÷ $10,000 income = 30% housing ratio

Total Debt Ratio

The back-end ratio includes your housing expense plus your other qualifying monthly debts.

Suppose you have:

• $3,000 proposed housing payment
• $500 car payment
• $200 minimum credit card payments
• $300 student loan obligation

Your total monthly qualifying debt would be:

$4,000

With $10,000 of qualifying monthly income:

$4,000 ÷ $10,000 = 40% total DTI

For many mortgage programs, this total DTI is the number that receives the most attention.

How Much DTI Is Too Much?

This is where mortgage qualifying gets more complicated.

There isn't one universal maximum DTI that applies to every borrower or every home loan.

The acceptable ratio can depend on factors such as:

• Loan program
• Automated underwriting findings
• Credit history and credit score
• Down payment
• Cash reserves
• Property type
• Occupancy
• Overall strength of the loan file

Conventional, FHA, VA and USDA loans can each treat DTI somewhat differently.

In some situations, automated underwriting may approve a borrower with a higher DTI than another borrower—even when both borrowers are applying for the same general type of loan.

Don't automatically assume your DTI is too high to qualify.

This is one of the areas where an experienced loan officer can make a significant difference.

Qualifying Income Isn't Always the Same as the Income You Earn

Here's another important point:

The income you actually earn isn't necessarily the same income a mortgage lender can use to qualify you.

Straight salary income can be relatively simple.

Other income may require additional analysis, including:

• Overtime
• Bonuses
• Commissions
• Part-time employment
• Self-employment income
• Rental income
• Retirement or pension income
• Social Security
• Investment income
• Other variable income

Mortgage guidelines determine whether the income has an acceptable history, whether it's likely to continue and how much of it can be used.

This is especially important for self-employed borrowers.

A business owner may have strong cash flow but show substantially less taxable qualifying income after business deductions.

That's why simply dividing your debts by the income you think you make may not accurately predict your mortgage DTI.

Student Loans Can Be Tricky

Student loan debt deserves special attention because the payment used for mortgage qualifying may not always be as simple as looking at the payment shown on your credit report.

The amount lenders must use can depend on the mortgage program and the documentation available.

If you have substantial student loan balances, have your loan officer review them before you start seriously shopping for a home.

Credit Cards: The Balance Isn't Usually the Important Number

Another common misunderstanding involves credit cards.

For DTI purposes, lenders are generally more concerned with the required monthly payment than the total outstanding balance.

For example, having a $10,000 credit card balance doesn't mean $10,000 is counted against your income.

It's generally the applicable monthly payment obligation that affects your DTI.

That also means paying down or paying off certain debts before purchasing a home can sometimes improve your qualifying ability substantially.

But don't start moving money around or paying off accounts solely to qualify without first discussing it with your loan officer. Depending on the situation, there may be a better way to structure the loan.

Car Payments Can Have a Huge Impact

A large auto payment is one of the most common obstacles I see when determining how much home someone can qualify for.

Consider a borrower earning $8,000 per month.

A $700 monthly car payment consumes 8.75% of that borrower's gross monthly income before we've even considered the new mortgage payment.

That can represent a significant amount of lost home-buying power.

If you're planning to purchase a home soon, think carefully before taking on a large new car payment.

How to Improve Your DTI

If your DTI is preventing you from qualifying for the loan amount you need, there may be several possible solutions.

Depending on your situation, we might look at:

• Paying off or reducing certain monthly debts
• Restructuring qualifying debts when permitted
• Increasing your down payment
• Documenting additional qualifying income
• Adding an eligible co-borrower
• Choosing a different mortgage program
• Looking for a lower homeowners insurance cost
• Adjusting the purchase price
• Finding a property with lower HOA dues or property taxes

Sometimes a relatively small change can make the difference between an approval and a denial.

Don't Make Major Financial Changes Before Closing

Getting pre-approved isn't the end of the DTI discussion.

Lenders may verify your credit, employment, income and debts again before your loan closes.

So while you're buying or refinancing a home, avoid taking on new debt without first talking with your loan officer.

That includes financing:

• A new car
• Furniture
• Appliances
• Home improvements
• Large credit card purchases
• Personal loans

A new monthly payment could increase your DTI enough to affect your loan approval.

If you're under contract on a home, call your loan officer before opening or financing anything new.

DTI Is Important—but It's Only One Piece of the Loan

Debt-to-income ratio is a major part of mortgage underwriting, but lenders don't evaluate DTI in isolation.

Your overall qualification may also depend on your:

Credit — Your credit scores and credit history.

Capacity — Your ability to repay the mortgage based largely on qualifying income and debts.

Capital — Your funds for the down payment, closing costs and reserves.

Collateral — The property being used as security for the mortgage.

A higher DTI doesn't necessarily mean you can't qualify, just as a low DTI doesn't automatically guarantee loan approval.

The entire loan profile matters.

The Bottom Line

Debt-to-income ratio sounds complicated, but the basic idea is simple:

How much qualifying income do you have compared with how much you're required to pay each month?

The difficult part is determining exactly which income a lender can use, which debts must be counted and which mortgage guidelines apply to your particular situation.

That's where experience matters.

Before assuming you can't qualify—or assuming an online mortgage calculator is accurate—have your actual income, debts and financial situation reviewed.

You may qualify for more than you think.

And if your DTI is currently too high, there may be ways to structure the loan or improve your qualifying position.

Have Questions About Your Debt-to-Income Ratio?

If you're buying or refinancing a home in California, I can review your income and monthly debts and explain exactly how the numbers work.

No sales pressure. Just straightforward answers and easy-to-understand home loan numbers.

A good pre-approval should tell you more than whether you qualify. It should help you understand why you qualify, how much you can comfortably spend and which loan structure makes the most sense for you.