Posted
on Tuesday, September 6, 2022
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Mortgage Lending
What is the Debt-to-Income Ratio and Why Does it Matter?
If you have a good credit score and a reliable income source, you may think you are the perfect candidate for a mortgage loan. But there may be an important factor that you haven’t considered – your debit-to-income ratio.
The debt-to-income (DTI) ratio is a metric used by lenders to determine the ability of a borrower to repay their debts and accumulate additional debt. The DTI ratio compares an individual’s monthly debt payments to their monthly gross income.
A higher ratio is unfavorable to lenders and indicates that a higher proportion of an individual’s income goes toward monthly debt payments.
For example, a DTI ratio of 25 percent means that 25 percent of the individual’s monthly gross income is used to servicing monthly debt payments. The maximum acceptable DTI ratio varies depending on the lender. As a guideline, at First National Bank the ideal DTI ratio should fall between 36 and 45 percent or be lower to obtain a mortgage loan.
DTI Ratio is Part of the Credit Analysis
Your DTI ratio is used during the credit analysis process to determine your credit risk. If you’re looking to get a mortgage loan, auto or personal loan, or a new credit card, your DTI ratio will be one of the top factors lenders will consider.
It is important to note that an individual with a DTI ratio of 20 percent does not necessarily mean they present less credit risk than an individual with a DTI ratio of 25 percent. The DTI Ratio serves as only part of the credit evaluation. A thorough credit analysis must be performed to accurately determine the credit risk of an individual.
Formula for Calculating Your DTI Ratio
Monthly Debit Payments: Refers to monthly bills such as rent/mortgage, car insurance, health insurance, credit cards, student loans, medical and dental bills, vehicle loan, child support payment, and other payments
Gross Income: Is the income of an individual before taxes and other deductions.
Practical Example
An individual seeking a mortgage loan with a total payment of $1,200, who also has a $250 car payment and $500 for other debts. If the gross monthly income of this individual is $4,000, which is their debt-to-income ratio?
($1,200 + $250 + $500) / $4,000 x 100 = 48.75% DTI Ratio
5 Ways to Lower Your DTI Ratio
If your ratio is slightly or significantly higher than the ideal percentage of 36 percent, you may want to consider lowering it before you apply for a new loan. Below are some actions you can take to improve your borrowing capacity.
- Avoid Acquiring New Debt. If you are looking to buy a home, now is not the time to buy a new car or apply for a credit card. Taking on new debt or adding to your credit card balance will drive up your DTI.
- Pay Down Your Debt. One way to tackle your existing debt is to use the Avalanche Method, addressing the debt with the highest interest rate first, which is typically your credit card. Knock off this debt first and work your way to the debt with the second highest interest rate.
- Find a Side Gig. Finding another stream of side income can be helpful in paying down your debt more quickly.
- Control Your Nonessential Spending. During COVID, we learned how to save by reducing trips to the store and not going out to eat. Two bad habits many people also learned during the pandemic was how to use Amazon to do all of their shopping (often for things that weren’t must-haves and at higher prices) and to place a food order online and have it delivered, rather than making a meal at home.
- Put Credit Cards on Ice. Stop buying things because you want them rather than need them.
- first-time homebuyer
- home equity line of credit
- mortgage refinancing