Your debt-to-income ratio is a measure of how big your monthly debt service obligations are as a percentage of your income. It’s one of the most important things lenders consider when assessing your application for a mortgage: The higher your monthly debt payments and the lower your income, the higher your DTI will be, and the more difficult it will be to qualify for a mortgage.
Note: Hawaii residents have the highest debt-to-income ratios in the country.
Broadly speaking, there are two ways to improve your DTI ratio: Reduce your monthly debt payments, and increase your income. The ideal solution will see improvements in both: We’d love you to improve your overall income and reduce any non-productive debt, such as credit card debt, car payments.
But first, let’s take a closer look at the DTI metric, because it’s critical to assessing your ability to pay off a home loan on a personal residence.
Front-end vs. Back-end DTI
Lenders look at two versions of your debt-to-income ratio: The “front-end” ratio and the “back-end” ratio.
Your front-end ratio is a measure of your housing-related costs relative to your monthly income. To calculate it, add up all your expected home-related expenses you anticipate if your mortgage is approved.
These expenses include:
• Your future mortgage payment
• Expected insurance payment
• Property tax payments
• Homeowner’s or condominium association fees
Divide the total of your monthly housing-related expenses by your monthly gross income and the resulting ratio is your “front-end” debt to income ratio.
The “back-end” ratio is more comprehensive, because it also includes not just housing-related expenses, but also your personal and lifestyle-related debts as well:
To calculate your “back-end” ratio, add up all your monthly housing-related expenses:
• Car loan or lease payments
• Minimum payments on all credit cards
• Monthly student loan payment
• Personal loan payments
• Medical debt payments
• Child support obligations
Normally, your “back-end” ratio is going to be a higher number than your front-end ratio.
To be eligible for the best conventional loan programs, you want to strive for a front-end ratio of about 28% or lower, and a back-end ratio below 36%.
If you’re applying for an FHA loan, however, you may be able to get approved with a higher DTI ratio – possibly up to 50 percent, but everything else needs to look outstanding in order for that to happen.
How to Improve Your DTI
Most lenders weight your back-end DTI more heavily than your front-end, because it’s a more complete snapshot of your overall financial situation.
So it’s usually a great idea to focus debt paydown issues on items included in your ‘back end.’
To make the most immediate impact, try to pay off one or more debts completely. For example, reducing a credit card balance to zero will completely eliminate one monthly payment – creating an immediate improvement in your debt-to-income ratio.
By the same token, paying extra on a car note certainly reduces your overall debt. But since car loans are usually fixed, level monthly obligations, unless you pay the whole thing off and therefore totally eliminate your monthly payment on that debt, it’s not going to move the needle.
Consider aggressively paying off all your debts, in order from smallest to largest, as much as you can – eliminating entire payments as quickly as possible, in order to quickly reduce your monthly debt service expenses and make the most immediate impact on your back-end DTI.
Another way to look at it: Try to pay off debts with fixed, level obligations first for more immediate DTI ratio improvement.
Also, strive to get your credit utilization ratio down below 30 percent at most, and preferably below 10 percent. That should help you quickly improve your FICO score, even as it has the happy effect of reducing interest you will owe each month and (probably) eliminating monthly payments.
Increasing Your Income
Of course, you can also improve your income in a variety of ways:
• Taking a second job
• Driving for Uber or Lyft
• Taking on freelance or contractor work
• Consulting
• Starting an internet business, selling on Amazon, Etsy or other platforms
• Switching jobs to a higher-paying one (in the same industry).
• Operate an in-home day care (make sure you are insured for this!)
• Teach English or other subjects online
• Become a mystery shopper
Taking all your extra income and using it to eliminate debt is a powerful combination: The DTI ratio still gives you credit for the income, even as you wrestle your debt balances down and eliminate monthly payments.
At the same time, you’ll want to squirrel money away for your down payment – and keep it in the bank for at least 60 to 90 days before applying for a loan, to meet lender “seasoning” requirements.
Also, lenders will consider the reliability of that income – the likelihood that your income stream will continue in the future. So look for ways to increase your income that are sustainable in the future.