The debt-to-income (DTI) ratio is a personal finance measure that compares an individual’s monthly debt payment to their monthly gross income. Your gross income is your pay before taxes and other deductions are taken out.
The debt-to-income ratio is the percentage of your gross monthly income that goes to paying your monthly debt payments. So, how do you calculate it? Let us find out.
- How do you Calculate Debt to Income Ratio?
- What Does the DTI Ratio Tell You?
- What is an Acceptable Debt to Income Ratio?
- How can I Lower my Debt to Income Ratio Quickly?
- How does Debt to Income Ratio Affect Mortgage?
- How to Improve your Debt to Income Ratio
- What is the Average Debt to Income Ratio in America?
- What is the Difference Between Front end and back end DTI?
- How can I get a Loan with a High Debt to Income Ratio?
How do you Calculate Debt to Income Ratio?
To calculate your debt-to-income ratio, you add up all your monthly debt payments and divide them by your gross monthly income. Your gross monthly income is generally the amount of money you have earned before your taxes and other deductions are taken out.
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For example, if you pay $1500 a month for your mortgage and another $100 a month for an auto loan, and $400 a month for the rest of your debts, your monthly debt payments are $2,000. ($1500 + $100 + $400 = $2,000.) If your gross monthly income is $6,000, then your debt-to-income ratio is 33 percent. ($2,000 is 33% of $6,000.)
Evidence from studies of mortgage loans suggests that borrowers with a higher debt-to-income ratio are more likely to run into trouble making monthly payments. The 43 percent debt-to-income ratio is important because, in most cases, that is the highest ratio a borrower can have and still get a Qualified Mortgage.
There are some exceptions. For instance, a small creditor must consider your debt-to-income ratio, but is allowed to offer a Qualified Mortgage with a debt-to-income ratio higher than 43 percent. In most cases your lender is a small creditor if it had under $2 billion in assets in the last year and it made no more than 500 mortgages in the previous year.
Larger lenders may still make a mortgage loan if your debt-to-income ratio is more than 43 percent, even if this prevents it from being a Qualified Mortgage. But they will have to make a reasonable, good-faith effort, following the CFPB’s rules, to determine that you have the ability to repay the loan.
The DTI ratio is one of the metrics that lenders, including mortgage lenders, use to measure an individual’s ability to manage monthly payments and repay debts.
- Sum up your monthly debt payments including credit cards, loans, and mortgage.
- Divide your total monthly debt payment amount by your monthly gross income.
- The result will yield a decimal, so multiply the result by 100 to achieve your DTI percentage.
For example, assume you pay $1,200 for your mortgage, $400 for your car, and $400 for the rest of your debts each month. Your monthly debt payments would be as follows:
- $1,200 + $400 + $400 = $2,000
If your gross income for the month is $6,000, your debt-to-income ratio would be 33% ($2,000 / $6,000 = 0.33). But if your gross income for the month was lower, say $5,000, your debt-to-income ratio would be 40% ($2,000 / $5,000 = 0.4).
What Does the DTI Ratio Tell You?
A low debt-to-income (DTI) ratio demonstrates a good balance between debt and income. In other words, if your DTI ratio is 15%, that means that 15% of your monthly gross income goes to debt payments each month. Conversely, a high DTI ratio can signal that an individual has too much debt for the amount of income earned each month.
Typically, borrowers with low debt-to-income ratios are likely to manage their monthly debt payments effectively. As a result, banks and financial credit providers want to see low DTI ratios before issuing loans to a potential borrower. The preference for low DTI ratios makes sense since lenders want to be sure a borrower isn’t overextended meaning they have too many debt payments relative to their income.
As a general guideline, 43% is the highest DTI ratio a borrower can have and still get qualified for a mortgage. Ideally, lenders prefer a debt-to-income ratio lower than 36%, with no more than 28% of that debt going towards servicing a mortgage or rent payment.
The maximum DTI ratio varies from lender to lender. However, the lower the debt-to-income ratio, the better the chances that the borrower will be approved, or at least considered, for the credit application.
What is an Acceptable Debt to Income Ratio?
DTI and Getting a Mortgage
When you apply for a mortgage, the lender will consider your finances, including your credit history, monthly gross income and how much money you have for a down payment. To figure out how much you can afford for a house, the lender will look at your debt-to-income ratio.
Lenders prefer to see a debt-to-income ratio smaller than 36%, with no more than 28% of that debt going towards servicing your mortgage.12 For example, assume your gross income is $4,000 per month. The maximum amount for monthly mortgage-related payments at 28% would be $1,120 ($4,000 x 0.28 = $1,120).
Your lender will also look at your total debts, which should not exceed 36%, or in this case, $1,440 ($4,000 x 0.36 = $1,440). In most cases, 43% is the highest ratio a borrower can have and still get a qualified mortgage. Above that, the lender will likely deny the loan application because your monthly expenses for housing and various debts are too high as compared to your income.
DTI and Credit Score
Your debt-to-income ratio does not directly affect your credit score. This is because the credit agencies do not know how much money you earn, so they are not able to make the calculation.
The credit agencies do, however, look at your credit utilization ratio or debt-to-credit ratio, which compares all your credit card account balances to the total amount of credit (that is, the sum of all the credit limits on your cards) you have available.
For example, if you have credit card balances totaling $4,000 with a credit limit of $10,000, your debt-to-credit ratio would be 40% ($4,000 / $10,000 = 0.40, or 40%). In general, the more a person owes relative to their credit limit—how close to maxing out the cards—the lower the credit score will be.
Lowering Debt-to-Income (DTI) Ratio
Basically, there are two ways to lower your debt-to-income ratio:
- Reduce your monthly recurring debt
- Increase your gross monthly income
Of course, you can also use a combination of the two. Let’s return to our example of the debt-to-income ratio at 33%, based on the total recurring monthly debt of $2,000 and a gross monthly income of $6,000. If the total recurring monthly debt were reduced to $1,500, the debt-to-income ratio would correspondingly decrease to 25% ($1,500 / $6,000 = 0.25, or 25%).
Similarly, if debt stays the same as in the first example but we increase the income to $8,000, again the debt-to-income ratio drops ($2,000 / $8,000 = 0.25, or 25%).
Of course, reducing debt is easier said than done. It can be helpful to make a conscious effort to avoid going further into debt by considering needs versus wants when spending.
Needs are things you have to have in order to survive: food, shelter, clothing, healthcare, and transportation. Wants, on the other hand, are things you would like to have, but that you don’t need to survive.
Once your needs have been met each month, you might have discretionary income available to spend on wants. You don’t have to spend it all, and it makes financial sense to stop spending so much money on things you don’t need. It is also helpful to create a budget that includes paying down the debt you already have.
How can I Lower my Debt to Income Ratio Quickly?
The lower your debt-to-income ratio, the better because it means you don’t spend much of your income paying debts. On the other hand, a high debt-to-income ratio means more of your income is spent on debt, leaving you with less money to spend on other bills or save and invest.
High Debt-To-Income Ratio
If your debt-to-income ratio is more than 50%, you definitely have too much debt. That means you’re spending at least half your monthly income on debt. Between 37% and 49% isn’t terrible, but those are still some risky numbers. Ideally, your debt-to-income ratio should be less than 36%. That means you have a manageable debt load and money left over after making your monthly debt payments.
Impact of a High Debt-to-Income Ratio
A high debt-to-income ratio can have a negative impact on your finances in multiple areas. First, you may struggle to pay bills because so much of your monthly income is going toward debt payments.
A high debt-to-income ratio will make it tough to get approved for loans, especially a mortgage or auto loan. Lenders want to be sure you can afford to make your monthly loan payments. High debt payments are often a sign that a borrower would miss payments or default on the loan.
While your credit score isn’t directly impacted by a high debt-to-income ratio, some of the factors that contribute to a high debt-to-income ratio could also hurt your credit score. More specifically, high credit card and loan balances, which may play a role in your high debt-to-income ratio, can hurt your credit score.
How to Reduce Your Debt-to-Income Ratio
There are times when having a high debt-to-income ratio makes sense. For example, it’s not terrible to have a high ratio if you aggressively paying off your debt. On the other hand, if your ratio is high and you’re only making minimum payments, that’s a problem.
Generally, there are two ways to lower your debt-to-income ratio. First, you can increase your income. That could mean working some overtime, asking for a salary increase, taking on a part-time job, starting a business, or generating money from a hobby.
The more you can increase your monthly income (without simultaneously raising your debt payments) the lower your debt-to-income ratio will be.
The second way to lower your ratio is to pay off your debt. While you’re in debt repayment mode, your debt-to-income ratio will temporarily increase because you’re spending more of your monthly income on debt payments. That’s because a higher percentage of your income will be going toward debt.
For example, if your monthly income is $1,000 and you currently spend $480 on debt each month, then your ratio is 48%. If you decide to spend $700 a month on debt payments, then your ratio would increase to 70%. But, when you’ve paid the debt all the way off, your ratio would drop to 0% because you’d no longer spend your income on debt.
How does Debt to Income Ratio Affect Mortgage?
There are many factors that lenders evaluate when considering you for a mortgage. One of the most important is your debt-to-income ratio, which indicates how much of your income your monthly debt takes up.
DTI requirements vary by loan type, so the threshold you’ll need to fall under will depend on what type of mortgage you choose. Here’s a quick look at what the general, minimum DTI requirements look like by loan type:
| Loan Type | Front-End DTI | Back-End DTI |
|---|---|---|
| FHA | 31% to 33% | 43% to 45% |
| USDA | 29% | 41% |
| VA | N/A | 41% (but lenders are free to go higher) |
| Conventional | 36% | 45% |
FHA Loans
FHA loans tend to have looser qualifying requirements than other loan types. On these mortgages, you can have a back-end DTI as high as 43% and still qualify, or even higher if there are compensating factors. If you’re applying for an FHA Energy Efficient Homes (EEH) mortgage, the DTI maximum goes up to 45%.
Your front-end DTI must be 31% or less (33% for EEH loans) without compensating factors. According to the Consumer Financial Protection Bureau, the median DTI of FHA borrowers is 44%.
USDA Loans
On USDA loans, also sometimes called rural housing loans, the DTI requirements are 29% on the front-end and 41% on the back-end. The CFPB shows that 36% is the median DTI for USDA borrowers.
VA Loans
The VA technically sets a maximum back-end DTI or 41%, but because military members often receive a lot of tax-free income that isn’t calculated into these ratios, lenders are free to go beyond the 41% threshold with no limits. In fact, according to the CFPB, the median DTI for VA borrowers is 42%.
Conventional Loans
On conventional loans, the maximum back-end DTI is 50%. There are tighter restrictions for DTI on “manual underwrites,” including a 36% to 45% cap on back-end DTI depending on your credit score and the amount of cash you have for reserves. The CFPB shows the median DTI of conventional borrowers is 37%.
How to Improve your Debt to Income Ratio
There are two ways to lower your debt-to-income ratio: lower your debt levels or increase your income.
For most of us, increasing our income is easier said than done. If a high debt-to-income ratio is preventing you from getting access to credit that you need, some lenders may allow you to apply with a co-applicant or add a co-signer to your loan and have that person’s income considered as part of your application. Although this may help you get approved for credit, it won’t actually lower your personal debt-to-income ratio.
The other way to improve your debt-to-income ratio is to lower your debt levels:
- Stop taking on more debt. Don’t apply for new credit, avoid running up your credit card balances, and delay any major purchases.
- Pay down existing debt. Evaluate different strategies for paying down your debt. For example, you might be able to streamline and lower your monthly debt payments with a debt consolidation loan, or you may be able to temporarily save on your monthly credit card bill with a balance transfer offer.
- Reduce your spending for the long haul. Revisit your budget to figure out where your money is going each month. Consider putting in place some better money habits to nudge yourself toward a more frugal lifestyle, and check out some hacks to avoid overspending. Use any extra money you have each month to make extra payments on your existing debts.
Your debt-to-income ratio is not included in your credit report or your credit score, but it is an important number to know because it’s a key financial health indicator that shows lenders if you’re living within your means.
Plus, if you have a high debt-to-income ratio you might also have a high credit utilization ratio, which does have a major influence on your credit score.
What is the Average Debt to Income Ratio in America?
Credit cards, student loans, mortgages, car loans, personal loans: Most Americans have a combination of these sources of debt. And despite their best intentions, Americans are digging themselves deeper into a hole each year.
The average American now has about $38,000 in personal debt, excluding home mortgages. That’s up $1,000 from a year ago, according to Northwestern Mutual’s 2018 Planning & Progress Study, which also reports that “fewer people said they carry ‘no debt’ this year compared to 2017 (23 percent vs. 27 percent).”
“Despite recognizing that debt is dangerous waters, Americans are jumping in with both feet and struggling to stay afloat,” says Emily Holbrook, director of planning for Northwestern Mutual.
Credit cards and mortgages tied as the leading source of debt, followed by student loans and car loans, according to the survey. The findings are based on a survey of over 2,000 U.S. adults, including an oversampling of more than 600 millennials.
Gen Z & younger millennials (ages 18-24): $22,000
For those ages 18 to 24, it’s no surprise that student loans are the highest source of debt (28 percent), followed by credit card balances.
At least experts consider student loans to be “good debt,” because they are typically low cost and may have tax advantages. Meanwhile, credit card debt is almost always “bad debt,” because it has much higher interest rates.
When it comes to student loans, don’t take out more, in total, than you believe you will make with your first year’s salary, Carrie Schwab-Pomerantz, a financial advisor, board chair and president of the Charles Schwab Foundation, tells CNBC Make It. So if you think you’re going to earn $50,000 right out of college, you shouldn’t have more than $50,000 in student loans.
Older millennials (ages 25-34): $42,000
Among older millennials, credit card balances are the leading source of debt, making up a fourth of what average older millennials owe. Student debt accounts for about 16 percent, while mortgages make up just 3 percent, according to Northwestern Mutual.
“As you grow older, your expenses increase. The additional pressures that come onto the pocketbook only grow, and your disposable income shrinks in a lot of cases, even if your salary is growing,” Holbrook tells CNBC Make It.
Gen X (ages 35-49): $39,000
For those ages 35 to 49, home mortgages are the No. 1 source of debt: They account for about 32 percent of the members of this age group typically owe, the survey finds. Credit card debt is the No. 2 source, while car loans and education debt tie for around 7 percent each.
This era in your life is crunch time, says Kevin O’Leary, personal finance author and co-host of ABC’s “Shark Tank.” People should aim to have all of their debt paid off — from mortgages to student loans to credit card debt — by age 45, he tells CNBC Make It.
“The reason I say 45 is the turning point, or in your 40s, is because think about a career: Most careers start in early 20s and end in the mid-60s,” O’Leary says. “So, when you’re 45 years old, the game is more than half over, and you better be out of debt, because you’re going to use the rest of the innings in that game to accrue capital.”
Baby boomers (age 50+): $36,000
Those who are age 50 or older have the second-lowest amount of debt, which is good news. And similar to Gen-Xers, the top three sources are, in order: mortgages, credit card bills and car loans.
But while they have less debt than millennials and Gen-Xers, many boomers don’t have a lot of savings, despite being close to retirement. A third of baby boomers have less than $25,000 put away for their golden years, according to Northwestern Mutual, meaning they could end up working longer than they planned.
What is the Difference Between Front end and back end DTI?
The front-end debt-to-income ratio (DTI) is a variation of the DTI that calculates how much of a person’s gross income is going toward housing costs. If a homeowner has a mortgage, the front-end DTI is typically calculated as housing expenses (such as mortgage payments, mortgage insurance, etc.) divided by gross income.
In contrast, a back-end DTI calculates the percentage of gross income going toward other debt types, such as credit cards or car loans. You may also hear these ratios referred to as “Housing 1” and “Housing 2,” or “Basic” and “Broad,” respectively.
Understanding the Front-End Debt-To-Income Ratio (DTI)
The DTI is also known as the mortgage-to-income ratio or the housing ratio. It may be contrasted with the back-end ratio.
To calculate the front-end DTI, add up your expected housing expenses, and divide it by how much you earn each month before taxes (your gross monthly income). Multiply the result by 100, and that is your front-end DTI ratio. For instance, if all your housing-related expenses total $1,000 and your monthly income is $3,000, your DTI is 33%.
What Is a Desirable Front-End Debt-To-Income Ratio (DTI)?
To qualify for a mortgage, the borrower often must have a front-end debt-to-income ratio of less than an indicated level. Paying bills on time, a stable income, and a good credit score won’t necessarily qualify you for a mortgage loan.
In the mortgage lending world, how far you are from financial ruin is measured by your DTI. Simply put, this is a comparison of your housing expenses and your monthly debt obligations versus how much you earn.
Higher ratios tend to increase the likelihood of default on a mortgage. For example, in 2009, many homeowners had front-end DTIs that were significantly higher than average, and, consequently, mortgage defaults began to rise. In 2009 the government introduced loan modification programs in an attempt to get front-end DTIs below 31%.
Lenders usually prefer a front-end DTI of no more than 28%. In reality, depending on your credit score, savings, and down payment, lenders may accept higher ratios, although it depends on the type of mortgage loan. However, the back-end DTI is actually considered more important by many financial professionals for mortgage loan applications.
When preparing for a mortgage application, the most obvious of strategies for lowering the front-end DTI is to pay off debt. However, most people don’t have the money to do so when they are in the process of getting a mortgage—most of their savings are going toward the down payment and closing costs. If you think you can afford the mortgage, but your DTI is over the limit, a co-signer might help.
What Is the Back-End Ratio?
The back-end ratio, also known as the debt-to-income ratio, is a ratio that indicates what portion of a person’s monthly income goes toward paying debts. Total monthly debt includes expenses, such as mortgage payments (principal, interest, taxes, and insurance), credit card payments, child support, and other loan payments.
Back-End Ratio = (Total monthly debt expense / Gross monthly income) x 100
Lenders use this ratio in conjunction with the front-end ratio to approve mortgages.
Break Down Back-End Ratio
The back-end ratio represents one of a handful of metrics that mortgage underwriters use to assess the level of risk associated with lending money to a prospective borrower. It is important because it denotes how much of the borrower’s income is owed to someone else or another company.
If a high percentage of an applicant’s paycheck goes to debt payments every month, the applicant is considered a high-risk borrower, as a job loss or income reduction could cause unpaid bills to pile up in a hurry.
Calculating the Back-End Ratio
The back-end ratio is calculated by adding together all of a borrower’s monthly debt payments and dividing the sum by the borrower’s monthly income.
Consider a borrower whose monthly income is $5,000 ($60,000 annually divided by 12) and who has total monthly debt payments of $2,000. This borrower’s back-end ratio is 40%, ($2,000 / $5,000).
Generally, lenders like to see a back-end ratio that does not exceed 36%. However, some lenders make exceptions for ratios of up to 50% for borrowers with good credit. Some lenders consider only this ratio when approving mortgages, while others use it in conjunction with the front-end ratio.
Back-End vs. Front-End Ratio
Like the back-end ratio, the front-end ratio is another debt-to-income comparison used by mortgage underwriters, the only difference being the front-end ratio considers no debt other than the mortgage payment. Therefore, the front-end ratio is calculated by dividing only the borrower’s mortgage payment by his or her monthly income.
Returning to the example above, assume that out of the borrower’s $2,000 monthly debt obligation, their mortgage payment comprises $1,200 of that amount.
The borrower’s front-end ratio, then, is ($1,200 / $5,000), or 24%. A front-end ratio of 28% is a common upper limit imposed by mortgage companies. Like with the back-end ratio, certain lenders offer greater flexibility on front-end ratio, especially if a borrower has other mitigating factors, such as good credit, reliable income, or large cash reserves.
How to Improve a Back-End Ratio
Paying off credit cards and selling a financed car are two ways a borrower can lower their back-end ratio. If the mortgage loan being applied for is a refinance and the home has enough equity, consolidating other debt with a cash-out refinance can lower the back-end ratio.
However, because lenders incur greater risk on a cash-out refinance, the interest rate is often slightly higher versus a standard rate-term refinance to compensate for the higher risk.
In addition, many lenders require a borrower paying off the revolving debt in a cash-out refinance to close the debt accounts being paid off, lest they run his balance back up.
How can I get a Loan with a High Debt to Income Ratio?
A high debt-to-income ratio can result in a turned-down mortgage application. Luckily, there are ways to get approved even with high debt levels.
1. Try a more forgiving program
Different programs come with varying DTI limits. For example, Fannie Mae sets its maximum DTI at 36 percent for those with smaller down payments and lower credit scores. Forty-five is the limit for those with higher down payments or credit scores.
FHA loans, on the other hand, allow a DTI of up to 50 percent in some cases, and your credit does not have to be top-notch.
Likewise, USDA loans are designed to promote homeownership in rural areas — places where income might be lower than highly populated employment centers.
Perhaps the most lenient of all are VA loans, which is zero-down financing reserved for current and former military service members. DTI for these loans can be quite high, if justified by a high level of residual income. If you’re fortunate enough to be eligible, a VA loan is likely the best option for high-debt borrowers.
2. Restructure your debts
Sometimes, you can reduce your ratios by refinancing or restructuring debt.
Student loan repayment can often be extended over a longer term. You may be able to pay off credit cards with a personal loan at a lower interest rate and payment. Or, refinance your car loan to a longer term, lower rate or both.
Transferring your credit card balances to a new one with a zero percent introductory rate can lower your payment for up to 18 months. That helps you qualify for your mortgage and pay off your debts faster as well.
If you recently restructured a loan, keep all the paperwork handy. The new account may not show up on your credit report for thirty to sixty days. Your lender will need to see new loan terms to give you the benefit of lower payments.
3. Pay down (the right) accounts
If you can pay an installment loan down so that there are fewer than ten payments left, mortgage lenders usually drop that payment from your ratios.
Or you can reduce your credit card balances to lower your monthly minimum.
You want to get the biggest reduction for your buck, however. You can do this by taking every credit card balance and dividing it by its monthly payment, then paying off the ones with the highest payment-to-balance ratio.
Suppose you have $1,000 available to pay down the debts below:
| Balance | Payment | Payment-to-balance ratio |
| $500 | $45 | 9.0% |
| $1,500 | $30 | 2.0% |
| $2,000 | $50 | 2.5% |
| $3,000 | $150 | 5.0% |
The first account has a payment that’s nine percent of the balance — the highest of the four accounts — so that should be the first to go.
The first $500 eliminates a $45 payment from your ratios. You’d use the remaining $500 to pay down the fourth account balance to $2,500, dropping its payment by $25.
The total payment reduction is $70 per month, which in some cases could turn a loan denial into an approval.
4. Cash-out refinancing
If you’re trying to refinance, but your debts are too high, you might be able to eliminate them with a cash-out refinance. The extra cash you take from the mortgage is earmarked to pay off debts, thereby reducing your DTI.
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When you close your refinance mortgage, checks are issued directly to your creditors. You may be required to close those accounts as well.
5. Get a lower mortgage rate
One way to reduce your ratios is to drop the payment on your new mortgage. You can do this by “buying down” the rate — paying points to get a lower interest rate and payment.
Shop carefully. Choose a loan with a lower start rate, for instance, a 5-year adjustable rate mortgage instead of a 30-year fixed loan.
Buyers should consider asking the seller to contribute toward closing costs. The seller can buy your rate down instead of reducing the home price if it gives you a lower payment.
If you can afford the mortgage you want, but the numbers aren’t working for you, there are options. An expert mortgage lender can help you sort out your debts, tell you how much lower they need to be and work out the details.
