This article is too good not to be shared so it’s copied from The Washington Post.
When it comes to qualifying for a loan to buy a home or to refinance your mortgage, there are plenty of numbers to consider, such as your credit score and the appraised home value. Perhaps one of the most important numbers is your debt-to-income (DTI) ratio, which compares the minimum payments on all debt you must make each month with your gross monthly income.
“The DTI ratio is one of the most important considerations lenders take into account when evaluating the risk associated with a borrower taking on another payment,” says Paul Buege, president and chief operating officer of Inlanta Mortgage in Pewaukee, Wis. “The lower the DTI ratio a borrower has, the more confident the lender is about getting paid on time in the future based on the loan terms.”
It’s not just the lender who benefits from knowing your DTI, says Buege.
“Calculating your DTI ratio can help you determine how comfortable you are with your current debt and whether you have enough income to take on a mortgage payment,” he says.
Your DTI tells a lender what percentage of your income is being consumed by debts, says Joseph Mayhew, chief credit officer of Evolve Mortgage Services in Frisco, Tex.
“Lenders like to see low DTI ratios because it means a borrower has excess income to cover unforeseen emergencies and to save for a rainy day,” says Mayhew. “As DTI ratios go higher, lenders become less willing to lend. In the eyes of a mortgage lender, a high DTI can signify poor credit management, living beyond your means and difficulty saving money for the future.”
How to calculate your DTI
A simple DTI calculation is to divide your total monthly obligations by your total monthly income to generate a percentage, says Mayhew. For example, if your total monthly debts are $1,000 and your total monthly income is $4,000, your DTI would be 25 percent.
However, not every monthly bill is included in your DTI.
“Lenders typically look at installment loan obligations, such as auto and student loans, as well as any revolving debt payments such as credit cards or a home equity line of credit,” says Buege. “Alimony and child support payments are also included. When calculating DTI ratios, lenders don’t include utilities, cable and phone bills or health insurance premiums. Medical bills are generally not included. Everyday items like food and gas are also not included when calculating DTI ratios.
Your mortgage payments, including principal, interest, taxes and insurance, are contained in the DTI calculation, but auto insurance and life insurance payments, 401(k) contributions, income tax deductions and college or private school tuition payments are not, says Mayhew.
What’s a good DTI?
While an ideal DTI would be 25 percent or less, says Buege, the lower the DTI the better. Various loan programs have different DTI ratio requirements.
“For consumers with a good credit history, stable income and a down payment of 5 percent or more, most lenders will easily lend up to 45 percent DTI,” says Mayhew. “Those with smaller down payments or problems in their credit history may find themselves limited to a DTI around 38 percent.”
If your DTI is between 45 and 50 percent, many lenders will still approve a loan, says Mayhew, but they will require a perfect credit history, a larger down payment of 20 percent or more and plenty of cash in the bank for an emergency. Applicants with a higher level of debt will usually need to reduce their debt and/or increase their income.