What Is A Good Debt-To-Income Ratio?

Securing a home loan is a significant milestone in the journey to homeownership, and achieving the dream of owning a house hinges on a borrower's financial health. Debt to income ratio (DTI) is a crucial component in this context, as it plays a pivotal role when determining your eligibility for a mortgage.

This reality raises the question of what a good DTI is for borrowers applying for a mortgage. Mortgage lenders prefer a lower DTI as this is an indication of a lower-risk borrower. It is still possible to get a mortgage loan with a higher DTI; however, this may lead to less-favorable loan terms.

Understanding the ideal DTI range and why it matters can help you gain valuable insight on optimizing your financial standing to land a home loan with the best possible terms. Whether you're a first-time buyer or moving to your second or third home, understanding the significance of your DTI in the mortgage approval process is essential to make your homeownership dreams a reality.

Debt-To-Income-Ratio: A Definition

Debt-to-income ratio (DTI) is a financial metric used by lenders, financial institutions and individuals to assess a person's or household's financial health and ability to manage debt. It's a crucial factor in determining whether someone is eligible for a loan, mortgage or other form of credit.

DTI is the portion of a borrower's gross monthly income that goes toward paying debts, including mortgage or rent, credit card payments, student loans, car loans, alimony, child support and other monthly debt obligations. When you apply for a mortgage, lenders use your debt-to-income ratio to assess your financial health and ability to manage debt.

How DTI Ratio Can Affect Your Credit Score

The relationship between your DTI and credit score is indirect but significant. Your credit score is a numerical representation of your creditworthiness, indicating how you handle debt as a borrower.

When you apply for a loan, your lender pulls your credit report. This report contains the last 7 years of your credit history, detailing your borrowing and payment behavior. It includes information on credit cards, loans, mortgages and other debts you have. While your credit score and report don't show if you have a higher DTI, your credit history is a record of how you've managed financial obligations over time.

In addition, one crucial factor in your credit score is your credit utilization ratio. This ratio compares the total amount of credit you're using to your total available credit limit. A higher credit utilization ratio, meaning you're using a significant portion of your available credit, can negatively impact your credit score.

For example, say your primary source of credit is two credit cards that allow you to take on $10,000 of debt altogether. If you carry a $5,000 balance month-to-month, you're utilizing 50% of your available credit. Higher ratios indicate mounting debt obligations, which can hurt your credit score. As a result, your credit utilization ratio can correlate with your DTI because they both reflect how much debt you're currently managing. Larger ratios suggest a borrower's higher risk of overextending themselves financially.

How To Calculate Your Debt-To-Income Ratio

Lenders usually express DTI as a percentage. To get this number, you divide your monthly debt payments by your income. To get the percentage, multiple that by 100.

Here’s an example for calculating your DTI: Say your gross monthly income (what you make before taxes) is $5,000. Your total monthly debt payments are as follows:

• $200 car payment
• $200 credit card payment
• $1,100 rent payment

So, your monthly debt obligations are $1,500 altogether. As a result, your DTI is: ($1,500 / $5,000) x 100 = 30%. This number is known as back-end DTI because it includes all your monthly debt payments instead of only counting your housing obligations (i.e. front-end DTI).

Remember, your monthly debt obligations are different than your total amount of debt. For instance, say you have a $250,000 mortgage. This number isn’t relevant to your DTI calculation; instead, your monthly mortgage payment (including property taxes and homeowners insurance) counts toward your total monthly debt obligations. Likewise, a personal loan affects DTI through the amount you owe per month, not the total outstanding balance.

What Lenders Consider A Good DTI

When borrowers apply for a mortgage, the lender gathers information to decide how much house borrowers can afford. One critical piece of information is DTI, which indicates the borrower’s capacity for a home loan. Remember, your budget must have room for a mortgage loan payment after your other loan payments are accounted for. Here’s how lenders view different DTI levels when assessing a borrower’s financial capability.

50% Or More

Lenders consider a DTI of 50% or more potentially prohibitive for a mortgage loan because at least half of the borrower's income goes toward servicing existing debts. Hefty debt obligations equal high risk, and borrowers with DTIs at or above 50% may have limited loan options and/or difficulty securing a loan. If you receive loan approval with this DTI level, your lender will typically bump your interest rate and require a larger down payment to compensate for the risk. 

36% – 49%

A DTI in this range suggests that while a significant portion of the borrower's income is allocated to debt payments, the borrower likely can take on a mortgage loan payment. Therefore, borrowers in this range will generally still qualify for loans but may encounter stricter requirements and less-favorable terms than those with lower DTIs.

35% Or Less

Lenders view DTIs of 35% or less as low and generally provide the best terms for borrowers with this ratio. This level of debt indicates that the borrower has a relatively small portion of their income dedicated to debt payments. As a result, lenders view this portion of borrowers as lower risk because of the increased financial flexibility. Borrowers in this DTI range are more likely to qualify for loans with better terms, lower interest rates and smaller down payment requirements.

What Debt-To-Income Ratio Do You Need For A Mortgage Loan?

The ideal debt-to-income (DTI) ratio for a mortgage loan can vary depending on the type of mortgage and the lender's specific requirements. However, there are some general guidelines to consider.

First, your lender will distinguish between your front-end and back-end DTI. Front-end DTI is the percentage of your gross monthly income that goes toward housing expenses, including your mortgage principal, interest, property taxes and homeowners insurance (often abbreviated as PITI). A common guideline is that your front-end DTI should not exceed 28% to 31% of your gross monthly income.

On the other hand, back-end DTI includes your housing expenses (PITI) plus all other monthly debt obligations, such as credit card payments, car loans, student loans and other debts. Lenders typically prefer a back-end DTI of 36% or less, but some may allow up to 50% for conventional loans.

In addition, government-backed loans, such as those insured by the Federal Housing Administration (FHA) or the Department of Veterans Affairs (VA), may allow higher DTIs, making homeownership more accessible to some borrowers. For example, borrowers can obtain an FHA loan with a DTI as high as 57%, while the Department of Veterans Affairs (VA) loans generally limit borrowers to 50%.

Remember that your credit score, employment history and overall financial stability also influence mortgage loan approval. Lenders assess your entire financial picture to determine your eligibility. So, you can still qualify for a home loan if you don't have a particularly low DTI. However, you may receive higher interest rates from lenders in this situation.

8 Steps To Take If Your DTI Is Too High

If your DTI falls in a higher range, it’s best to improve your financial position before applying for a loan. The following steps can help you reinforce your financial profile and reduce your DTI:

1. Check your credit report. Review your credit report for inaccuracies. Erroneous debts can portray your DTI as higher than it is. You’ll also boost your credit score by cleaning up your credit reports.

2. Improve your credit score. Because lenders consider each aspect of your financial strength, high credit score could be a compensating factor to improve your chances of qualifying.

3. Boost your savings account. A financial cushion demonstrates your ability to cover unexpected expenses, assuring your lender of your financial abilities.

4. Pay off your lowest debt balances. For instance, a low credit card balance or auto loan may detract from your DTI. In these cases, paying these balances in full will increase your capacity for a new loan.

5. Avoid taking on new debt. Opening new credit accounts or taking on additional loans increases your monthly debt load, hurting your DTI. Remember, co-signing on loans also counts toward your DTI.

6. Increase your income. If possible, take an opportunity to increase your income by asking for a raise at your job, taking on part-time work or looking for a higher-paying position.

7. Consolidate and refinance loans. Consolidating and refinancing can lower your monthly minimum payments and interest rates. These tools can transform your monthly budget, reducing debt obligations and creating room for a mortgage loan.

8. Increase your down payment. A larger down payment lowers your mortgage loan balance after you purchase a home. As a result, you’ll have a lower monthly mortgage payment, alleviating your need for a stellar DTI.

The Bottom Line: Mortgage Lenders View Lower DTI As Lower Risk

A borrower's DTI is a crucial financial metric that impacts your eligibility for loans and mortgages. It represents the portion of your monthly income dedicated to debt payments, including housing expenses, credit cards, and loans. Lenders prefer a lower DTI for favorable mortgage terms because this percentage indicates a borrower's ability to handle a new debt payment without straining their budget.

To improve your financial profile and your chances of securing a mortgage, consider steps like enhancing your credit score, building savings, paying off smaller debts, avoiding new debt, increasing income and exploring loan consolidation or refinancing options. If you have your credit score and DTI where you want them, you can take the first step of starting your application today.