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How to Calculate Debt-to-Income Ratio for a Mortgage

Unless you come by a huge influx of cash either by winning the lottery or through an inheritance; a mortgage remains the most affordable way to own a home. Among the tools that lenders uses to determine your eligibility for a home loan is debt-to-income ratio, or DTI.

The ratio is used to determine how much of your income can go towards monthly mortgage payments as compared to other monthly debts that your income settles. Read on to find out how to calculate DTI and what ranges are desirable according to the industry standards.

What is DTI and how is it calculated

The US Consumer Protection Financial Bureau defines DTI as ‘all your monthly debt payments divided by your gross monthly income’ expressed as a percentage. Mortgage lenders consider two different types of DTI ratios: Front-end and Back-end. We will get to them shortly but before you get down to the calculations, you need to;

STEP 1. Determine your monthly liabilities. These include;

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Monthly Home-related costs – If it is your first mortgage this will be sum of all monthly expenses that go towards paying your rent. It has to be expressed as a monthly amount i.e. if you pay an annual sum then divide it by 12. Similarly if you pay it quarterly, divide by 4. Add in the proposed or expected monthly payment for the mortgage you are considering.

Also included in this will be other housing costs such mortgage insurance, real estate taxes and homeowner’s association payments. In case you are a homeowner in the market for a second mortgage, the monthly payments you make towards your first mortgage will constitute the cost.

Although you could be paying monthly for utilities like power and gas, they are not taken into account in this summation. Same goes for food, health and car insurances, phone bill, your taxes and cable bill.

Monthly loan payments – A sum of all monthly loans that are deducted from your pay and show on your credit report. These include monthly remittances towards car loan, student loan, credit union and personal bank loans.

Monthly credit card payments – This is the sum of minimum payments that you make for each credit card. It excludes credit card debt that you settle monthly in full.

Other monthly obligations – This could be any other line of credit that involves financing. Monthly child support or alimony payments fall under these obligations.

TIP: Monthly liabilities= (Home related costs + loan payments + credit card payments + others)

Step 2. Determine your monthly gross income

This refers to your total pay before any deductions are made or simply pre-tax pay. This comprises of;

  • Basic wages or salary.
  • Bonuses and commissions
  • Alimony and or child support.
  • Income from investments (must be verifiable via your tax returns)

Tip: If you draw a salary, bonus or commission annually then divide it by 12 to arrive at its monthly value.

How to Calculate the Front-end Ratio

This is the home-related costs divided by your monthly gross income. It shows the amount of monthly income that can be freed to service the house loan you propose to get. To put this into context, suppose your monthly gross income is $6,000 and total monthly home-related costs are $1,500.

Front-end DTI = ($1500/ $6000) * 100 = 25%

How to Calculate the Back-end ratio

When lenders speak of DTI, this is mostly what they have in mind. It’s a ratio that shows the amount of your income that goes towards settling all your debts. It’s the sum of all monthly debts divided by your monthly gross income. Suppose your total monthly liabilities (including home related costs) in the above example is $2500 then,

Back-end DTI= ($2500/ $6000) *100 = 41%

Standards for Debt-to-income Ratio  

A low DTI means that you have more of your income left after paying bills. Back-end ratio of 36% and front-end ratio of 28% or below is considered favorable by most lenders.

Back-end ratios of between 36%-49% translate to less amount left to spend. Lenders will view you as a potential defaulter. You may have to contend with higher interest rates and huge down payments for your loan.

Anything higher than 50% puts you on the red. It means half of your pay is going toward debt payments leaving you with little to spend or even take up a new financial obligation. This greatly reduces your chances of landing a mortgage.

How to improve your Debt-to-income Ratio

For better mortgage terms your DTI should be as low as possible. This can be achieved by taking a part-time job or increasing your overtime to boost your income. Work aggressively towards clearing your credit card debts before applying for the loan. You may also consider saving for huge purchases like a car rather than racking up more credit.

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