Understanding Debt-to-Income Ratio

In This Article

Understanding your debt-to-income (DTI) ratio is crucial for making wise investment decisions. Your DTI impacts your ability to qualify for loans, lock in low interest rates, and take advantage of the best financial deals. A high DTI ratio means you are carrying a lot of debt and are a potential risk to lenders.

When applying for a mortgage loan, the lender checks your ability to manage debt obligations and meet your financial responsibilities. One critical indicator is your debt-to-income ratio—the percentage of your gross monthly income that goes toward paying monthly debt payments.

This article delves into what the debt-to-income ratio is, how to calculate it, and how to improve your DTI ratio. By the end, you will have a solid grasp of this important financial concept and be better equipped to make informed financial decisions.

What Is Debt-to-Income Ratio?

The debt-to-income ratio is a financial metric to compare your monthly debt obligations to your total monthly income before taxes. The DTI indicates if you have manageable levels of debt in relation to your income. High debt levels can indicate whether you would struggle to make monthly mortgage payments.

The DTI ratio helps lenders evaluate your creditworthiness and financial health in the mortgage application process. For example, suppose your monthly financial obligations are low compared to your income. In that case, you can likely make your monthly mortgage payment and have room to absorb additional unexpected expenses. 

However, suppose a large proportion of your income goes toward servicing debt. In that case, a lender may refuse your application because of your heavy debt load. 

Of course, it’s not the only financial metric lenders use. Mortgage lenders also consider the type of loan, your credit score, credit history, loan terms, employment history, and the size of your down payment. 

In addition to the mortgage process, lenders use the DTI ratio when approving auto, personal, or larger loans.

How to Calculate DTI Ratio

Calculating your debt-to-income ratio gives you a good idea of your financial situation. The DTI calculation is straightforward. All you need to do is add up the total monthly debt payments and divide them by your gross monthly income. Then, multiply the result by 100 to get a percentage score.

Components

Income and debt are the two main components of the DTI calculation. Let’s break down the debt-to-income ratio calculation to show which type of debt your lender uses.

• Income: Your income should include the pre-tax income you earn each month. You can also include someone else’s income if you include them on the loan. Here are various types of income to include in the calculation:
  • Pre-tax earnings from your primary job
  • Income from rental properties
  • Earnings from investments, like dividends, capital gains, and interest
  • Income from part-time jobs or other sources
• Debt: Only monthly payment amounts should be included when calculating your debt level. You shouldn’t use total debt balances on credit cards or auto loan balances in the calculation. Here are various types of debt payments for calculating your DTI ratio:
  • Monthly rent or mortgage payment
  • Minimum payments on all credit cards
  • Student loan payments
  • Auto loan payments
  • Child support or monthly alimony payments
  • Monthly expenses relating to property taxes, homeowners insurance, or homeowners association (HOA) fees

It’s important to remember that certain expenses are omitted from your current debt obligations. These include utility payments, 401(k) or IRA contributions, transportation costs, or health insurance premiums.

DTI formula

The debt-to-income ratio formula divides your total monthly debts by your gross monthly income. The result is a decimal figure that you convert into a percentage. 

The formula for calculating your DTI is as follows:

DTI ratio = ([Minimum monthly debt payments] ÷ [Gross monthly income]) x 100

Here’s how the DTI formula works in practice. Suppose your monthly debt payments are as follows:

• Mortgage payment: $1,600
• Combined minimum credit card payments: $400
• Auto loan minimum payment: $600

This means your monthly debt payments would be $2,600. 

Let’s say your pre-tax monthly earnings are $7,000. We can work out your DTI as follows:

Debt-to-income ratio calculation: ($2,600 ÷ 7,000) x 100 = 37%

Because your DTI ratio is under 43%, you have a good chance of getting approved for a loan. The lender sees you have enough income to cover mortgage payments, even if you have some unexpected expenses. 

Back-End vs. Front-End Debt-to-Income Ratios

Front-end DTI and back-end DTI are different metrics for measuring your financial health. The front-end DTI focuses solely on housing costs, while the back-end DTI ratio considers all your debts. Let’s consider these metrics in more detail.

Back-end DTI ratio

The back-end ratio calculates the level of monthly debt obligations in relation to your earnings. The calculation includes minimum payments for auto loans, credit cards, and personal loans. You should also include child support payments, if applicable. However, common household expenses—transportation, utilities, food, and entertainment—are not included. 

Your back-end DTI is the figure most lenders focus on, as it provides a more comprehensive view of your monthly expenses.

A good back-end DTI ratio is typically between 33% and 36%. Although some lenders may be happy with a DTI of up to 43%, below 36% is considered good. Typically, you must meet stricter criteria when applying for a loan with a higher DTI ratio. Therefore, you should aim to lower your debt-to-income ratio as much as possible before applying for a mortgage.

The formula for the back-end DTI ratio is the same as for the standard DTI calculation. Add up your monthly debt obligations, and divide by your gross monthly income. 

Front-end DTI ratio

The front-end ratio—called the housing ratio—only considers the proportion of your income that goes toward your housing payment. Housing costs include the following: 

• Mortgage principal
• Investment property mortgage payments
• Interest
• Property taxes
• Homeowners insurance
• Landlord insurance

The front-end ratio is a good way to determine if you can afford the mortgage.

To calculate the DTI ratio, add up your total housing-related expenses and then divide it by your gross monthly income.

Let’s say a house buyer has an income of $7,000, and the mortgage payment will be $1,650. In that case, their front-end DTI is 23%.

Ideally, the figure for front-end DTI should be 28% or lower. A higher front-end ratio may mean higher interest rates. However, your lender may approve the loan application if you have a front-end ratio between 30% and 36% and an excellent credit score.

The Importance of DTI Ratio in Real Estate

The DTI ratio in real estate is vital because it shows your creditworthiness. Lenders want to ensure you can repay the loan and meet all your debt obligations. To determine the risk, they calculate the proportion of your monthly income that goes toward repaying debts. The higher the DTI ratio, the greater the risk of defaulting. 

How lenders use DTI ratios

Lenders use DTI ratios along with your credit health, employment history, and the size of the down payment to calculate the borrowing risk. A high DTI ratio indicates that paying down the level of debt will be difficult. Therefore, borrowers with DTI ratios over 50% have very limited borrowing options. 

However, there are some options to secure a loan with a high DTI. For example, you could have a cosigner on the mortgage documents. Alternatively, you could extend the loan term to lower the DTI ratio. Other options include paying off credit card debt or selling a car bought through financing. 

Remember that lenders base the DTI ratio on your expenses after the loan is approved. For example, suppose you’re refinancing and consolidating debts. In that case, your qualifying DTI will reflect your expenses after the debts are consolidated. 

Or say you are renting, and the new housing costs are higher than the rent price. Your qualifying DTI will be based on the new mortgage payment.

How the DTI ratio affects real estate financing

The debt-to-income ratio directly impacts your ability to secure the best real estate financing deals. You must prove to the bank, credit union, or private lender you can manage the additional debt associated with real estate investing. Even if a lender approves a loan with a high DTI, you may have to meet more stringent terms. 

Here are three ways DTI ratios can affect real estate loans:

• Mortgage approvals: Getting a conventional loan with a higher DTI ratio will be difficult. Most lenders require a DTI lower than 43% before approving a mortgage application.
• Interest rates: A higher DTI could result in higher interest rates, as it implies a greater borrowing risk. Lenders typically offer the best interest rates to investors with high credit scores and low DTIs.
• Loan amount: Lenders must ensure you can meet your financial obligations. Therefore, if you have a heavy debt load, the lender may reduce the amount they are willing to lend. A larger loan amount usually requires a good-to-excellent DTI ratio.

What Is a Good Debt-to-Income Ratio?

A good DTI depends on the loan type. Usually, the lower the debt-to-income ratio, the better your chance of securing a mortgage loan. Generally, a DTI below 50% is considered acceptable in real estate investing. 

Here is a breakdown of what is considered a good DTI ratio:

• DTI below 36%: This shows you have reasonable levels of debt. You should have no problem applying for lines of credit or a new real estate loan. 
• DTI 37% to 41%: You have reasonable, manageable debt levels. Lenders typically approve mortgages if you have a ratio in this range and a good credit history. 
• DTI 42% to 49%: Lenders may use extra scrutiny during the loan application process to check your financial health. They could think that paying off this level of debt may be difficult. However, they will consider your whole financial picture before approving a mortgage loan.
• DTI over 50%: This indicates you have a high debt burden and may struggle to make monthly mortgage payments. Lenders typically refuse applications with DTIs over 50%. 

Certain government-backed loans may allow higher DTS. Here are a few:

• FHA loans: DTI ratio of up to 57%
• USDA loans: DTI ratio of up to 41%
• VA loans: DTI of up to 60%
• Conventional loan: DTI of up to 50%

In many cases, the lender determines your risk as a borrower. 

What is ideal for real estate?

Any ratio below 43% is considered good in real estate investing. However, reducing your debt-to-income ratio as much as possible makes financial sense because you can access the best mortgage products. If your DTI is between 43% and 50%, your lender may require you to have greater cash reserves to secure the real estate loan. 

How to Reduce Your DTI

Reducing your DTI ratio is essential for improving financial health and increasing borrowing capacity. A lower DTI can help expand your mortgage loan options and lock in better interest rates. Also, you maximize your returns because you use less cash to pay interest on debt.

Here are a few simple ways to knock a few points off your DTI ratio:

• Pay down debt: If possible, make extra payments toward your debts, or consider debt consolidation. Focus on paying down high-interest debt like credit cards. This will help to lower your DTI. Consolidating loans can help secure lower interest rates and reduce monthly payments. At the same time, avoid taking on more debt.
• Boost your income: You could consider taking on a side hustle, freelancing, or working more hours. Increasing your household income on a regular basis lowers your DTI ratio over time. 
• Cut expenses: Look at ways to cut down on your monthly expenses. Even though household utilities and transportation don’t affect your DTI directly, cutting outgoing expenses gives you extra cash. You can use this to reduce your debt burden. 

It is also a good idea to recalculate your debt-to-income ratio monthly. This way, you can monitor your progress to ensure you are effectively managing your debt.

Debt-to-Income Ratio Example

Let’s look at an example to see how DTI ratios work when it comes to applying for a loan. 

Suppose a real estate investor has a current monthly income of $9,500 and wants to secure a loan to buy a rental property. The investor calculates their current debt obligations are $4,375. In this case, their DTI ratio would be 46%. Using the DTI formula, they see that reducing monthly expenses—or increasing income—by $500 could slash their score to 40%. 

However, there are a few caveats that can affect the ratio. First, the real estate investor may be able to calculate predicted rental income, which may reduce the debt-to-income ratio. But this applies only if it’s more than the monthly mortgage payment. 

Additionally, the investor could consider a larger down payment, thus reducing the size of the mortgage. Or they could consolidate debt if they find deals with lower interest rates. Or the investor may pay down current debts to lower their DTI ratio.

In any case, it’s best to speak with a financial advisor about various loan options. This way, you can secure the best financial deals and maximize your return on investment.

Final Thoughts

Knowing how the debt-to-income ratio works is key to successful real estate investing. A low DTI of 43% or less shows a good balance between debt and income, making you a low-risk borrower. 

Ultimately, lowering your DTI maximizes your return on investment because you earn more money and pay less of your hard-earned cash servicing debt. 

Remember that the DTI ratio is not just a number—it is the key to unlocking financial success and building wealth.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.