Consumer debt in the US has reached over $14 trillion, however, this debt can be across a number of categories. This chart using data from Experian highlights that for the average American, 71.7% of consumer debt relates to mortgages. This is followed by 10.1% for both student loans and auto costs.
This highlights that for most consumers their home purchase represents their largest amount of debt.
Debt-to-income ratio is one of the main key elements lenders use to determine the creditworthiness of a borrower. The ratio compares your debt burden to the size of your monthly payments. In addition to other financial records, lenders use this ration to determine whether or not they will grant you a loan.
Overall, you’ll be in the position to receive the loan amount you desire with a low debt-to-income ratio. You’ll qualify for lower mortgage rates as well.
When you apply for a loan, DTI lenders may consider one of two factors:
- Front-end DTI includes all of your regular monthly housing expenses, such as your mortgage or rent, home or renters insurance, property taxes, and homeowners association fees. It excludes utilities, phone bills, and other similar expenses.
- Back-end DTI includes all of the above-mentioned monthly housing expenses, as well as any additional monthly debt payments, such as credit card minimum payments, student loans, personal loans, and auto loans.
What is a Good Debt-to-Income Ratio For Mortgage?
For a mortgage with low interest and favorable borrowing terms, your debt-to-income ratio needs to be 28 percent or less. The back-end number, including all monthly debts, should not be higher than 36%. You might be able to get a mortgage with a higher ratio, but it will not have low interest.
Overall, if an individual wants to qualify for a good mortgage loan, his debt-to-income ratio can’t be any more than 43%. Lenders consider qualifying mortgages as home loans that have features that solidifies that buyers can pay their loan back. For instance, lenders don’t apply excessive fees to qualifying mortgages. Moreover, qualified mortgages also help prevent borrowers from negative loan products such as bad amortizing loans, which can lead them to financial hardship.
If you DTI is higher than 36%, it means that you're managing your debt well, but you should think about lowering your DTI. This may put you in a better position to deal with unexpected expenses. If you want to borrow money, keep in mind that lenders may require additional eligibility criteria.
What is a Good DTI For Credit Cards and Personal Loans?
If you are applying for a personal loan or new credit card, the lending company will look at your debt-to-income ratio before determining if you will be able to get funding or not. Lenders typically say that your debt-to-income ratio should not be more than 28%. 20% or less is considered ideal though because it shows you are not a risky borrower.
Including all expenses, your debt-to-income ratio should not be more than 36%. Depending on the lender though, some will even accept a debt-to-income ratio as high as 50%, but this is quite rare. Keeping your debt-to-income ratio under 36% is a very wise thing to do. Moreover, this will increase the probability of you getting a loan.
How To Calculate Debt-to-Income Ratio
Your debt-to-income ratio is the percentage of your overall monthly income that you have that goes towards debt. You calculate this ratio by adding all of your monthly debt payments and dividing those monthly payments by your gross monthly income. Moreover, that amount is what you earn prior to taxes being taken out.
For instance, let's say your monthly housing expense is $2,400 and gross monthly income of $8,000. Also, if you are paying $300 a month on your auto loan, and $400 per month on your additional debts. Then, your DTI for . ($300 + $400). To calculate your front-end DTI, divide your total monthly housing expenses by your gross monthly income. To calculate your back-end DTI, add your monthly housing expenses and debt payments, then divide the total by your gross monthly income.
- Front-end DTI : $2,400/$8,000 –> 30%
- Back-end DTI: ($2,400 + $700)/$8,000 –> $3,100/$8,000 –> 38.7%
What If My Debt-to-Income Ratio Exceed 43%?
Lenders desire to grant loans to borrowers that have low debt-to-income ratios. A ratio higher than 43% sends a red flag to the lender. From the lender’s perspective, an individual with a high debt-to-income ratio can’t afford to have any additional debt. Use a mortgage calculator before seeing a lender will let you know what type of house you can afford having.
Even though 43% is the maximum amount of debt-to-income ratio that homebuyers can possess, they can benefit well from having a lower ratio. 36% or lower is the ideal debt-to-income ratio that lenders like to see in emerging homeowners. You might get stuck with a high interest rate or longer repayment terms. Try to lower your debt-to-income ratio before you apply for a mortgage so you can get the most favorable terms.
If you DTI is higher than 50%, you should work on paying off your debt before applying to another debt. With more than half of your income going toward debt payments, you may not have much left over to save, spend, or deal with unexpected expenses. Lenders may limit your borrowing options if your DTI ratio is this high.
Don’t be ashamed of having to wait an additional year to purchase your first home. We recommend for you to get your financial house in order and improve your credit score and history before applying.
Home Loans That Don’t Require DTI
Typically, most lenders use the DTI (debt-to-income) ration to determine whether or not homes are affordable for U.S. homebuyers. Lenders also have to verify your income debts in order to move forward with the process. On the contrary, there are many high-mortgage programs that totally disregard the DTI calculation.
Streamline finances is available with the FHA, VA, and Fannie Mae & Freddie Mac.
The FHA Streamline Refinance
This type of streamline refinance option totally disregards the DTI requirements that are current for an FHA purchase loan.
Furthermore, the FHA rules for an agency’s streamline refinance program refrain the income verification and credit scoring requirements as part of the approval process. Instead, the FHA examines whether or not a homeowner has been making his payments on time with no problems.
The FHA determines whether or not a homebuyer can pay the bill if he can present forth a perfect payment history dating back to at least 3 months. In other words, you DTI have no play in regards to the FHA Streamline Refinance process.
The VA Interest Rate Reduction Refinance Loan (IRRRL)
This is another program that waives the DTI requirements so you don’t have to worry about it. IRRRL and FHA Streamline Refinance are similar to one another. According to the IRRRL rules, they want homebuyers to have a strong payment history in regards to paying their mortgage. They want to view your paystubs and W-2s to verify this information.
The VA Streamline Refinance is available for borrowers who are in the military that can prove they can benefit from the refinance in either in the form of a monthly payment that’s lower or from a change in the adjustable rate mortgage to a fixed rate loan.
The Home Affordable Refinance Program (HARP)
HARP is another type of refinance programs that disregards the DTI calculation. Moreover, Fannie Mae and Freddie Mac allow homeowners to replace “money in the bank” for verifying income under HARP 2.0.
The HARP 2.0 rules state that lenders aren’t required to collect your tax returns nor your pay stubs if you are a homeowner that can prove that you have a minimum of 12 months in PITI in reserve, in addition to having a perfect mortgage payment history of the last 6 months and 11 of the last 12 months.
Keep in mind that lenders do have the right to verify your income by using HARP; some even make the choice to do it.
How To Improve Debt to Income Ratio?
Maintaining a low debt-to-income ratio will help ensure that you can afford your debt repayments and will provide you with the peace of mind that comes from managing your finances responsibly. It can also increase your chances of getting credit for the things you really want in the future. Here are our suggestions:
- Pay off your debts – If possible, ret to pay off your debts first in order to reduce your DTI and credit utilization ratio. Make a list of all the debt payments you make each month. Which of your debts requires the most money each month? You can also try to reduce that payment by extending your repayment period. In general, you optimize your DTI ratio whenever you can afford to make more than the minimum payments.
- Change Habits & Don't Accumulate More Debt – Don't apply for new credit, keep your credit card balances low, and postpone any major purchases. Consider lowering the amount you charge on your credit cards and deferring the application for additional loans. To do so, you'll need to know how much money you're spending and set some spending limits. Consider developing better money habits to nudge yourself toward a more frugal lifestyle, as well as investigating some hacks to avoid overspending. Automatic payments are always a good idea because they keep you from falling into the trap of late payments.
- Track and adjust – follow your debt-to-income ratio on a monthly basis to see if you're making progress. Seeing your DTI decrease can help you stay motivated to keep your debt under control. Most banks provide some sort of spending tool that allows you to see where you're spending the most money. You can also look at different categories and compare them month to month or over a specific time period. That way, you'll be able to see where your spending is getting out of hand.
What is the Fastest Way to Raise Debt-to-Income Ratio?
When attempting to improve your debt-to-income ratio, your primary focus should be on reducing your monthly debt obligations in relation to your income. As a result, it makes sense to target debt based on the size of your monthly payments rather than the overall size of the debt.
Are you nearing the end of a loan, such as an auto loan? Do you have enough money to pay off one or more credit cards? If you can get rid of any debt, you will be able to reduce your monthly debt payments and quickly lower your DTI.
Even if your total credit card debt is much lower, paying it off will improve your debt-to-income ratio more because your payment represents a larger portion of the balance.
Is DTI Affect to Your Credit Score?
Credit utilization has an impact on credit scores, but debt-to-credit ratios do not. Your debt-to-income ratio is not factored into your credit score.
Because income information is not included on your credit report, credit reporting agencies are unable to calculate DTI. DTI also does not reflect your credit status: you can have a good credit score and a clean credit report while still having a high debt-to-income ratio. Credit agencies cannot calculate your income because they do not know how much you earn. Furthermore, banks and other types of lenders set their own DTI standards, so a DTI that is acceptable with one lender may be considered too high by another.
Credit agencies, on the other hand, consider your credit utilization ratio or debt-to-credit ratio, which compares all of your credit card account balances to the total amount of credit (the sum of all the credit limits on your cards) that you have available.
Overall, remember that the more debt you have, the higher your ratio will be. If your ratio is too high, the more at risk you are from a financial perspective. To continue the course that leads to financial freedom, you have the power to calculate the DTI ratio each quarter to ensure that you are going in the right direction.
Furthermore, you need to go in a different direction if your DTI ratio shows that you are struggling financially.
Build or Rebuilding Credit - FAQs
The majority of negative credit information usually remains in your credit report for a minimum of seven years. Additionally, if you filed for bankruptcy, this information will remain on your Equifax credit report for anywhere between 7 and 10 years.
However, the length of time largely depends on the type of bankruptcy you filed for. Any closed accounts will be paid in your Equifax credit report as agreed for up to 10 years.
So, take a look at some things you could be doing to help improve your credit history.
Most experts agree that paying someone to fix your credit is a waste of time and money. It’s also worth noting that a credit repair company cannot repair your credit. This is because they do not have some kind of special access to the three credit bureaus (TransUnion, Experian, and Equifax) that allows them to alter information in your favor.
In addition, the credit bureaus will not delete credit information just because you hired a credit repair company. Anything that a credit repair company can do for you is no more effective than what you can do on your own.
Paying the final debt may feel free, but it will not necessarily improve your credit score. Worse, it may actually cause your score to drop, although this may be counterintuitive.
Generally, paying off your credit card helps reduce your credit utilization because your balance accounts for a small percentage of your overall credit limit.
However, if you close the account that has just been paid off, you will lose the credit limit of the account, and now your other balances account for a larger percentage of the total.
Your credit card payments are recorded to the credit bureaus every time you make a payment. This results in a positive note on your credit report, which helps to improve your credit score. As a result, make sure you pay your monthly bills on time every month.
However, another part of paying off credit cards that can help you improve credit is your credit utilization ratio. This is the ratio of your debt to your credit limits. Your credit utilization ratio is 30 percent if you have total credit limits of $1000 and balances totaling $300. This is a key consideration while making a loan selection.
Most credit card companies offer balance transfers, which means you can move your debt from one card to another. However, unless you are inside an introductory period, you should be aware that this may result in fees. You should also think about the interest rates on both cards. It's pointless to transfer debt if the rate difference is offset by the balance transfer cost.
If you do decide to transfer your credit card balance to another card, you should opt for a card with a low introductory rate. This will allow you to pay off your credit card debt without paying a lot in interest rates.