Are You Ready for Home Ownership? Understanding Your Debt-to-Income Ratio

Are you ready to buy a home? The first step in buying a house is determining your budget. With all the costs that go into buying a home, it can seem tricky to figure out what you can actually afford.

To understand what you can afford in a home, it’s important to first understand your debt-to-income ratio, or DTI.

What is a Debt-to-Income (DTI) Ratio?

Your debt-to-income ratio is the total of your monthly debt payments – like car payments, personal loans, college loans, and other debts – divided by your gross monthly income. Lenders use your DTI when you apply for a mortgage loan to calculate what monthly mortgage payment you can manage.

Lenders look at two separate types of debt-to-income ratios:

• Front-end ratio: This is the percentage of your income that goes toward housing expenses, including your monthly mortgage payment, property taxes, homeowners' insurance and homeowner association fees. Lenders typically allow this to be between 28% - 35%.
• Back-end ratio: This shows how much of your income would be needed to cover all monthly payments. In addition to the mortgage and housing expenses, this includes credit cards, student loans, auto loans, and all other debts. Lenders typically allow this to be between 35% - 50%.

To calculate your DTI, add up your monthly debt payments and divide them by your gross monthly income – the amount you earned before taxes and deductions are taken out.

For example, let’s say your total monthly debt payments add up to $2,200:

And your gross monthly income is $6,000. Here’s how to find your DTI:

Your DTI is 37%.

Related content:

Mortgage Pre-Approval Checklist for Arizona 

What is a Good Debt-to-Income Ratio?

You may see different DTI limits for different lenders and different loan products, but lenders typically don’t want to see your debts plus housing costs – including mortgage, homeowners association fees, property tax, etc. – totaling any more than 50% of your monthly income. Depending on the scenario and institution, DTI requirements may range from 36-50%. The lower you are on that range, the better.

The Federal Housing Administration uses a 43% debt-to-income ratio as a guideline for approving mortgages. This means all your monthly debt payments plus your housing expenses shouldn’t equal more than 43% of your monthly gross income.

Having a lower debt-to-income ratio shows lenders that you are likely able to manage your monthly debt payments well. Lenders want to ensure that you won’t be taking on too much with your home loan and will be able to make your payments.

How to Lower Your Debt-to-Income Ratio

If you’re ringing up on the higher end, you can either pay off debt faster or work to increase your income. Using the example DTI from earlier, if you were able to pay off your student loan debt and eliminate that $200/month, your new DTI would be 33%.

If your debt stays the same but your income increases to $7,000, that brings your DTI down to 31%.

It’s important to determine your DTI early on in the homebuying process so you can work to get that percentage down, if needed, to qualify for a home loan.

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What’s a Good Front-End DTI?

Lenders use your income and debt to determine your allowable monthly payment and then create the mortgage amount from there. Then they’ll determine how big of a mortgage you qualify for based on the current interest rates, the loan term you choose and the amount you put down.

Often though, you’ll be approved for a larger mortgage than you may realistically be able to handle. A good rule of thumb is to keep your total mortgage payment at 30% or below your take-home pay. This total mortgage payment refers to the total of the principal, interest, taxes and insurance payments.

Use a mortgage calculator to determine what type of home is in your budget.

Let’s say again that your current take-home pay is $6,000/month. Using the 30% rule, you know you can afford to make a total monthly mortgage payment of $1,800.

Next, using a mortgage calculator, you will find the home price you can afford is $258,000 on a 30-year loan at 6.5% interest. Keep in mind, this calculation includes a 10% down payment of $25,800, therefore creating a mortgage for $232,200.

Now that you know your debt-to-income ratio, are you ready for home ownership? Contact our mortgage team today to get prequalified.