Calculating your debt-to-income ratio
Your debt-to-income ratio is exactly what it sounds like: the ratio of the amount of debt you have compared to your income. And it can be a very important number when lenders are determining your eligibility for a loan. A low DTI demonstrates prudent financial decisions, and is generally preferable to lenders. Higher DTI ratios may prevent you from qualifying for a home loan, simply because it shows that your extended credit is, in a sense, maxed out. In other words, you don’t have enough income to cover more debt.
How to Calculate Your Debt-to-Income Ratio
- Determine your gross (before tax) monthly income from all sources.
- Add up your prospective housing expense (mortgage principal and interest plus taxes, insurance, HOA dues, etc.)
- To the housing expense, add your monthly debt payments like credit card, auto and student loan payments (but not living expenses) and divide that by your gross income.
Mortgage lenders use the debt-to-income ratio calculations to determine how much of your income is used for paying your mortgage and other installment debts such as credit cards, student loans and vehicle loans. The lower your debt-to-income ratio, the better your financial health.
Follow these steps to calculate your debt-to-income ratio:
Determine Monthly Gross Income
Add the monthly gross income earned by all borrowers. Important: Your gross income is the amount earned before income taxes and other costs are deducted from your pay. Write down your monthly gross income amount(s). If you are paid weekly, multiply your weekly gross income by 52 and divide the result by 12. If you are paid every two weeks, multiply your pay by 26 and divide the result by 12.
List Estimated Mortgage Payment and Fixed Monthly Payments
Gather your estimated mortgage payment amount and latest fixed installment account statements. Fixed installment accounts include monthly credit card payments, student loan payments, vehicle payments, loan payments and family support payments if any. Don’t include utility bills or miscellaneous expenses.
List the estimated amount of your new mortgage payment. This amount includes principal and interest (P&I). Your estimated mortgage payment may also include amounts collected for paying property taxes, hazard insurance and mortgage insurance.
Next, list the minimum required payment for each installment debt. Check your most recent account statements for each minimum monthly payment amount. Important: List only the minimum required payment for each account, even if you pay more. Do not include your account balances.
Do the Numbers
You’re ready to calculate your debt-to-income ratio.
Add your estimated mortgage payment and minimum required payment amounts. Write down the total.
Divide the total of your estimated mortgage payment and fixed installment payments by the amount of your gross monthly income. Suppose that your estimated mortgage payment is $2,000 and your total minimum monthly payments on installment accounts is $500. The total is $2,500.
Divide the total of your estimated mortgage payment and monthly minimum payments by your monthly gross income. In John and Joan’s example, dividing $2,500 by $7,500 gives a result of .33, which is 33 percent.
Why Your Debt-to-Income Ratio Matters
Mortgage lenders establish maximum acceptable debt-to-income ratios as part of the process of approving home loans. Acceptable debt-to-income ratios can change as mortgage lenders and other authorities revise their mortgage approval guidelines.
Estimate your debt-to-income ratio to determine how your finances compare with mortgage lender requirements. Under new mortgage laws that became effective January 10, the maximum debt-to-income ratio for “qualified” mortgage loans is 43 percent.
Things to Keep in Mind
Mortgage approval requirements vary between loan programs and from lender to lender. If your debt-to-income ratio doesn’t work with one lender, try another. FHA and VA loans allow higher debt-to-income ratios, but also carry a loan guarantee fee (VA loans) and FHA mortgage insurance premiums.
Conventional loans made with less than a 20 percent down payment require private mortgage insurance (MI)
Ask questions! If your debt-to-income ratio is too high, don’t give up. Ask about other loan programs or suggestions for lowering your debt-to-income ratio. Pay down consumer debt or increase your down payment to lower your debt-to-income ratio.