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When you go to apply for a mortgage, your lender will look at a handful of different factors that make up your financial situation. One factor that has a huge impact is your debt-to-income ratio. Below, we’ll take an in-depth look at what a debt-to-income ratio is, how it’s used, and how to improve your own ratio.
What is a debt-to-income ratio?
Put simply, your debt-to-income ratio (DTI)Â is the sum of all your monthly debts divided by your gross monthly income.
For example, if you have an $800 rent payment, $400 car payment, and $3oo student loan payment each month when you bring home $3,000 a month after taxes, your debt-to-income equation would look like this:
($800 + $400 + $300)/ $3,000 =0.5
With those numbers, you have a 50% debt-to-income ratio.
How are debt-to-income ratios used?
The debt-to-income ratio is a measurement that lenders use to gauge how likely borrowers are to pay back their debts. The theory is that, if a borrower has too much existing debt, they’re more likely to run into trouble making additional recurring monthly payments. With that in mind, most lenders put a cap on the debt-to-income ratio that they will accept if they’re going to approve you for a loan.
These days, mortgage lenders look for a DTI of 50% or less. In the wake of the financial crisis of 2008, financial institutions like Fannie Mae and Freddie Mac had tightened up their standards and only accepted DTI’s of 45%, but they recently loosened up a bit in light of the strengthening economy.
How to improve your debt-to-income ratio
If your debt-to-income ratio is too high to buy a home right now, don’t worry. There are a few things you can do to bring it down:
Pump up your income
The first thing you can do to change your debt-to-income ratio is to increase your income. You can do that by getting a side hustle or by adding another applicant to the loan application. However, remember that if you add a co-signer to the loan, they’ll have to meet all the qualifications for the loan, as well, including credit score.
Reduce or reorganize your debts
If you can’t increase your income, the other option to change your debt-to-income ratio is to reduce your monthly debts. If you can, start looking at ways to pay down your debts. Alternatively, consider refinancing to lower your interest rates and your monthly payments overall.
Talk to a lender
If you have a lot of work to do on your debt-to-income ratio, one of the smartest things that you can do is to talk to a lender. He or she can look over the specifics of your financial situation and help you pinpoint the changes that will make the biggest difference in your ratio.