In this article:
- How Does Debt-to-Income Ratio Work?
- What Should My Debt-to-Income Ratio Be?
- Debt-to-Income Ratio and Mortgages
- Does Debt-to-Income Ratio Affect Your Credit Score?
- How Can I Improve My Debt-to-Income Ratio?
Lenders have different definitions of the ideal debt-to-income ratio (DTI)—the portion of your gross monthly income used to pay debts—but all agree that a lower DTI is better, and a DTI that's too high can tank a loan application.
Lenders use DTI to measure your ability to take on additional debt and still keep up with all your payments—especially those on the loan they're considering offering you. Knowing your DTI ratio and what it means to lenders can help you understand what types of loans you are most likely to qualify for.
How Does Debt-to-Income Ratio Work?
To calculate your DTI ratio, add up your recurring monthly debt payments (including credit card, student loan, mortgage, auto loan and other loan payments) and divide the sum by your gross monthly income (the amount you make each month before taxes, withholdings and expenses).
Here's an example of what your monthly debt obligations might look like:
| Debt | Monthly payment |
|---|---|
| Mortgage (includes property tax & homeowners insurance) | $1,150 |
| Student loan | $380 |
| Credit card No. 1 (minimum payment) | $170 |
| Credit card No. 2 (minimum payment) | $120 |
| Auto loan | $480 |
| Total | $2,300 |
If your total monthly debts as listed above were $2,300 and your gross monthly income was $5,200, your DTI ratio would be $2,300 divided by $5,200, or 0.44. DTI is commonly expressed as a percentage, so multiply by 100 to get 44%.
Most lenders use this figure, sometimes referred to as your back-end DTI, along with your credit score to gauge your creditworthiness.
Mortgage lenders considering loan applications may factor in a third measurement, known as front-end DTI. This is the portion of your gross income that goes toward housing costs—rent or mortgage payments, property taxes, homeowners insurance, condo or homeowners association fees, and so on. Taking another look at the example above, if your housing costs are $1,150 and your gross monthly income is $5,200, your front-end DTI would be $1,150 divided by $5,200, or 22%.
What Should My Debt-to-Income Ratio Be?
There is no "perfect" DTI ratio that all lenders require, but lenders tend to agree a lower DTI is better. Depending on the size and type of loan they're issuing, lenders set their own limits on how low your DTI must be for loan approval.
Debt-to-Income Ratio and Mortgages
Your DTI ratio is a major factor in the mortgage approval process. There are many different types of mortgages, and each has its own DTI requirements. Knowing your DTI ratio can help you narrow down which might be best for you.
Conventional Mortgages
A conventional home loan or mortgage is a type of loan that is not backed by the government and is given to the borrower directly from a bank, credit union or mortgage lender. Conventional loans are also known as conforming loans because they meet the requirements for purchase by Fannie Mae and Freddie Mac, the government-sponsored enterprises that buy almost all single-family home mortgages and package them into securities that are traded like stocks. These loans require borrowers to have back-end DTI ratios below 43%, although many lenders prefer DTI ratios no greater than 36%. For borrowers with high credit scores and sufficient assets or other income sources (collectively known as "compensating factors"), the maximum DTI on a conforming loan can be as high as 50%.
Unconventional Mortgages
An unconventional home loan or mortgage is a loan backed by a government agency such as the Federal Housing Association (FHA) or the Veterans Administration (VA). When evaluating applications for unconventional mortgages, lenders follow FHA guidelines that allow them to consider both front-end and back-end DTI ratios.
FHA guidelines call for front-end DTI ratios of no more than 31% or back-end DTI ratios no greater than 43%, but permit higher DTIs under certain circ*mstances. For instance, applicants with back-end DTIs as high as 50% may qualify for FHA loans if their credit scores are greater than 580 and they can provide documented proof of access to cash reserves or additional income sources.
Debt-to-Income Ratio and Other Loans
While mortgage lenders are almost always concerned with DTI ratios, issuers of other types of loans may be less so. If your credit score is high enough to meet their lending criteria, providers of personal loans and auto loans may only require proof of employment and income to approve your loan application.
If your credit scores fall below the lender's threshold, and they ask about your other debts and calculate your back-end DTI ratio, their minimum DTI requirements are likely to be stricter than those required by mortgage lenders.
Does Debt-to-Income Ratio Affect Your Credit Score?
DTI ratio has no effect on your credit score: Credit scoring systems such as the FICO® Score☉ and VantageScore® calculate credit scores using your history of credit usage and repayment as compiled in credit reports at the national credit bureaus (Experian, TransUnion and Equifax). Because the bureaus do not track your income, credit scoring software cannot calculate DTI ratios or factor them into your scores.
Debt, of course, influences both your DTI ratio and your credit score. Among the debt-related factors that influence credit scores are:
- Overall outstanding debt
- Credit mix—the number and variety of loans and credit accounts you're managing
- Credit utilization—the percentage of your credit card borrowing limits represented by your outstanding credit card balances
- Payment history—how consistently you've kept up with your debt payments, making them on time and paying them in full each month
How Can I Improve My Debt-to-Income Ratio?
Improving your debt-to-income ratio means lowering it, and doing so requires some combination of two things: reducing your monthly debt and increasing your income.
On the debt-reduction side of the equation, your options may be limited. Long-term student loan or mortgage payments may not be something you can easily change. If you have credit card debt, however, paying down your balances will reduce your minimum monthly payments and lower your DTI ratio. If you've got a personal loan or car loan, waiting until it's paid off before you seek a mortgage will also let your application reflect a lower DTI ratio.
With respect to income, negotiating a better salary or trading up to a better paying job is easier said than done (and if it were possible, you'd have probably done so already, without needing inspiration in the form of your DTI). If you feel you deserve a raise and can document the reasons why, it can't hurt to ask. Otherwise, consider pursuing a "side hustle" that earns you some extra income.
Lenders consider debt-to-income ratio an important metric for gauging your ability to handle additional loan payments. Calculating your own DTI ratio can help you understand your eligibility for various loans and can guide your loan-application process accordingly.
