When a lender processes your mortgage application, one of the most important factors it’ll consider is your debt-to-income ratio. If your ratio is too high, you may get approved for a mortgage with a high interest rate, which could add tens of thousands of dollars to your payments over the term of the loan–or your application may be denied, even if you have a good credit score and a steady job with a substantial income.
What Is Debt-to-Income Ratio?
DTI is calculated by adding up monthly debts and dividing by gross monthly income to arrive at a percentage. Some lenders factor in utilities, food, health insurance, transportation and other costs, while others don’t. Most don’t factor in student or car loans if they’re almost paid off.
Lenders generally want a borrower to have a debt-to-income ratio of 36 percent or below. They use an applicant’s DTI to figure out whether to approve a mortgage application, how much an individual can afford in mortgage payments and what interest rate to offer.
What to Do If Your DTI Is Too High
If your DTI ratio is above a lender’s guidelines, you should focus on lowering it before you apply for a mortgage. If you have a lot of debt, work on paying it down and avoid making large purchases with credit cards before you apply for a mortgage. You might also want to ask your boss for a raise or take on a second job or a part-time gig to earn extra money to put toward debt.
Don’t Automatically Borrow the Amount a Lender Approves
If a lender doesn’t consider all monthly expenses, it may approve a borrower for a larger mortgage than the person can reasonably afford. If your lender didn’t factor in all your expenses when calculating your DTI, you shouldn’t borrow the full amount the lender will allow because doing so could leave you unable to afford all your bills.
DTI is based on gross income. Depending on your income, where you live, your tax bracket and other circumstances, your actual disposable income may not be enough to cover all your bills if your lender approves you for a large mortgage.
Focus on Your DTI
Your DTI ratio is a key factor that a lender will use when assessing your mortgage application. If it’s high, work on lowering it and getting yourself on solid financial footing before you apply for a mortgage. If a lender approves your loan application, be sure to look at your after-tax income and all your debts and expenses to figure out how much you can afford so you don’t take on a larger mortgage than you can repay.
This article is intended for informational purposes only and should not be construed as professional or legal advice.
