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What is debt-to-income ratio?

Your Glossary_Term: debt-to-income ratio (or DTI) will play an important part in Glossary_Term: mortgages, Glossary_Term: refinancing and Glossary_Term: home equity loans or Glossary_Term: lines of credit. But what is it exactly? Simply put, it is the percentage of your monthly income that is taken up by your monthly Glossary_Term: debt payments.

Glossary_Term: Lenders look at your existing debt payments plus the projected payment for the new loan, and then calculate what percentage that represents of your total pre-tax income. This percentage is your debt-to-income ratio, which is one of the factors lenders use to decide whether or not to extend you a loan or line of credit. Generally, the lower your debt-to-income ratio is, the more likely you are to qualify.

How to calculate it

Lenders calculate your debt-to-income ratio by using these steps:

  1. Add up the amount you pay each month for debt and recurring financial obligations (such as credit cards, car loans and leases, or student loans). Don’t include your current mortgage or rental payment or other monthly expenses that aren’t debts (such as phone or electric bills) in this number.
  2. Add your projected future mortgage, home equity loan or line of credit payment to your debt total from step 1.
  3. Divide that total number by your monthly pre-tax income. The resulting percentage is your debt-to-income ratio.

For example, if your monthly income is $5,000 and your monthly debts plus your monthly projected mortgage, home equity loan or line of credit payments are $1,000, your debt-to-income ratio would be 20%.

Lowering your debt-to-income ratio

Most lenders will want your debt–to-income ratio to be no more than 36%, but some lenders or loan products may require a lower percentage in order to qualify.

If your DTI ratio is too high, consider how you can lower it. You might be able to pay down your credit cards or reduce other monthly debts. If the proceeds from your current home’s sale plus your savings allow it, you may also want to increase the amount of your down payment, in order to lower the projected Glossary_Term: monthly mortgage payment. Or you may want to consider a less expensive home.

Also keep in mind that there are alternative sources of income. Some lenders may consider other non-traditional sources of income (for example, trust income or housing allowance) in addition to your traditional income. Be sure to ask your lender about the availability of mortgage products and programs that allow the use of non-traditional sources of income.

By understanding what your debt picture looks like, you can develop a plan to tackle it.