What is debt-to-income ratio (DTI) and how does it affect your mortgage?

If you're a first-time homebuyer, the mortgage process may, at times, seem overwhelming. Even if you earn a steady income and pay your bills on time, there are other considerations that could affect your chances of getting a mortgage. Debt-to-income ratio (DTI) is just one such metric that lenders will look at to assess your financial situation. Let’s take a closer look at what the ratio means, how it’s calculated and why it matters for loan approval.

What is debt-to-income ratio (DTI)?

Your debt-to-income ratio (DTI) measures the amount of debt you have against your overall income. It’s just one way that lenders assess your financial health and creditworthiness. If a large chunk of your income goes toward paying down your debt, that means your DTI is high. In contrast, if a small percentage of your income is spent on your debt, your DTI is low. Lenders typically want to see that your DTI is low, as it tells them you'll be able to manage your monthly payments with minimal issues.

Lenders also look at the history and trajectory of your debt-to-income ratio. Say, for example, you increased your income from $100,000 to $250,000 in a year. A home lender may not automatically underwrite a much larger loan — they’ll want to understand the why behind the jump. Was it a big salary increase? A one-time sale of a house or stocks? Will that $250,000 income continue?

How to calculate debt-to-income ratio

The easiest way to calculate your debt-to-income ratio is to add up all your monthly debt payments and divide that amount by your gross monthly income.

The formula for calculating your DTI is as follows:

DTI = (Total of your monthly debt payments / your gross monthly income) x 100

The result is expressed as a percentage.

Debt-to-income ratio example

If you pay $1,500 a month for your mortgage, another $200 a month for an auto loan and $300 a month for remaining debts, your monthly debt payments add up to $2,000. If your gross monthly income is $6,000, then your debt-to-income ratio is 33 percent ($2,000 is 33 percent of $6,000).

On the other hand, if your gross monthly income is $6,000, and you are paying $3,000 in monthly debt, your debt-to-income ratio is 50 percent. In this case, you would be considered "house poor", a term used to describe homeowners living beyond their means by spending most of their income on housing costs (including mortgage, taxes and insurance).

Why is debt-to-income ratio important?

In addition to your income, lenders will review related housing expenses such as condominium dues and homeowner association assessments, insurance premiums, mortgage insurance and other recurring obligations.

While a high credit score is considered good, a low debt-to-income ratio is a more important factor. This is because it helps lenders see the bigger picture where your finances are concerned, providing reassurance that you’ll be able to make your monthly payments. Put simply, the information helps lenders minimize the risks associated with approving your loan.

How to lower your debt-to-income ratio (DTI)

If you’re concerned about your debt-to-income ratio, there are a few ways to approach the situation. You can reduce your DTI by increasing your income or paying off loans and credit card accounts. If your lender will not calculate earnings from side jobs as income, you can use the extra money to pay down debt. You can also allocate funds from bonus pay or a cash windfall to reduce debt.

Lenders also look at student loan debt when calculating debt-to-income ratio. Whether it will count against you depends on the type of loan and whether the payments are current or have been deferred.

Debt management to-do list

If you’ve decided that you’re going to buy a home and want to reduce your debt-to-income ratio, here’s a to-do list that might help.

• Make sure your credit is in order. Check your free annual credit report to make sure there aren’t any discrepancies and to keep track of your credit score.
• Figure out your debt-to-income ratio. Determine how much more debt you can handle without drastically tipping the scales.
• Understand how much you can afford as a down payment. Are those funds ready to use, or will you get help from your family?
• Have a cash cushion. Home lenders will look at how many months of cash reserves you have, so you should have enough saved to keep making mortgage payments for a few months if your income dips unexpectedly. 
• Double-check your comfort level. Ask yourself again: Are you truly comfortable borrowing an amount into the six figures and making that monthly mortgage payment?

In summary

Your debt-to-income ratio is a metric that compares your debt payments to your income. Lenders use this ratio to determine how you’ll be able to manage debt, plus additional loan payments. Understanding this ratio and what lenders are looking for — namely, a low debt-to-income ratio — could help you prepare your finances for the homebuying journey.