"I have too much debt to buy a home.”
Many believe that their amount of debt will be an instant hurdle when qualifying for a home loan. This is not always true. The amount of your debt will not necessarily be a red flag to lenders, but your debt-to-income (DTI) ratio might be. This number is one way lenders measure your ability to manage your monthly payments and repay the money you plan to borrow. Understanding DTI is important, especially when you are looking to purchase a new home.
What is Debt-to-Income Ratio?
A debt-to-income, or DTI, ratio is derived by dividing your monthly debt payments by your monthly gross income. This ratio is expressed as a percentage, and lenders use it to determine how well you manage monthly debts and whether you can afford to repay a loan.
How can you calculate Debt-to-Income?
In order to figure your debt-to-income ratio, you need to determine your total monthly gross income from all sources, before taxes. Then, determine what your monthly debt payments are such as your car, credit card payments, and housing. The final step in calculating your debt-to-income ratio is to divide your total monthly debt payments by your monthly gross income and convert this into a percentage. That percentage is your debt-to-income ratio!
Housing: + $1200
Auto loan: + $400
Credit card payments: + $300
Monthly debt total = $1900
Monthly income gross / $5500
1900 / 5500 = .3455
0.3455(100) = 34.55
Debt ratio = 35%
Take this calculation a step further and see how much home you can afford.
Why Does Debt-to-Income Matter?
Awareness of your DTI is crucial when it comes to determining your financial standing. A good debt-to-income ratio is considered one below 35%. According to the Consumer Financial Protection Bureau, “Evidence from studies of mortgage loans suggest that borrowers with a higher debt-to-income ratio are more likely to run into trouble making monthly payments.” Among other factors, a lower DTI ratio will make you more successful in securing a home loan. Lending companies are not the only entities that will look at your DTI. If you’re interested in applying for a credit card or an auto loan, lenders may use your debt-to-income to decide if lending you money is worth the risk.
Decreasing Debt-to-Income Ratio
Wondering how you can maintain or, perhaps, decrease your debt-to-income ratio? There are really only two factors in the above equation that will change the percentage: a higher income, or lower debt. Decreasing your credit utilization by paying down debts is the best way to decrease this number. Need help lowering your debt-to-income ratio or have questions about how your debt will impact the purchase of your dream home? Talk to our credit specialists now.