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Your debt-to-income ratio plays a large role in whether youâ€™re ready and able to qualify for a mortgage. This figure, the percentage of your income that goes toward paying your monthly debts, helps lenders figure out how big a monthly mortgage payment you can handle. Itâ€™s as important as your credit score and job stability, if not more so.
Lenders calculate your debt-to-income ratio by dividing your monthly debt obligations by your pretax, or gross, income. Most lenders look for a ratio of 36% or less, though there are exceptions, which weâ€™ll get into below.
This ratio, known in the mortgage industry as a DTI, helps you answer the question, â€œHow much house can I afford?â€ and is a useful guide for mortgage lenders trying to figure out how much you can borrow.Â But your DTI is not the whole story â€” it leaves out unavoidableÂ monthly expenses such as food, utilities, transportationÂ costs and health insurance, among others. Itâ€™s important to keep those obligations in mind as you evaluate your ability to afford a home.
Hereâ€™s how DTIs work:
There are two kinds of debt-to-income ratio:
The front-end ratio, also known as a household ratio, is the dollar amount of your home-related expenses â€” your proposed monthly mortgage, property tax, insurance and homeowners association fees â€” divided by your monthly gross income.
The back-end ratioÂ includes all the other debts you pay each month â€” such asÂ credit cards, student loans, personal loans and car loans â€” in addition to proposed household expenses. Back-end ratios tend to be slightly higher, since they take into account all of your monthly debt obligations.
While mortgage lenders typically look at both types of DTI, the back-end ratio often holds more sway because it takes into accountÂ your entire debt load.
Lenders tend to focus on the back-end ratio forÂ conventional mortgages,Â loans that are offered by banks or online mortgage lenders rather than a government program.Â IfÂ your front-end DTI is below 28%, thatâ€™s great. If your back-end DTI is below 36%, thatâ€™s even better.
When youâ€™re applying for a nonconventional mortgage, like anÂ FHA loan, lenders will look at both ratios and will consider DTIs that are higher than those required for a conventional mortgage: up to 31% for the front end and 43% for the back end. Sometimes lenders will even allow the ratios to go slightly higher.
Ideally, though, youâ€™ll want DTIs that are as low as possible, regardless of the lenderâ€™s limits. A lower DTI will help yourÂ credit score, which willÂ in turn allow you to get a lower mortgage interest rate.
Although DTIsÂ are important in getting a mortgage, theyâ€™re not enough when it comes to helping you figure out what you can afford, says Ira Rheingold, executive director of the National Association of Consumer Advocates.
â€œYou can have these general guidelines around debt-to-income ratio,â€ he says, â€œbut the bigger question is, will you, once you have that mortgage payment, have sufficient money to make ends meet?â€
Since DTIs donâ€™t take into account expenses such as food, health insurance, utilities, gasoline and entertainment, youâ€™ll want to budget beyond what your DTI labels â€œaffordable.â€ Aiming below the 36% back-end target is ideal.
This is especially important since your DTIs count your income before taxes, not what you actually take home each month.
The higher your DTI, the more likely youâ€™ll be to struggle to make your monthly mortgage payments. Youâ€™ll want to lower your DTI not just to qualify for a mortgage and buy the home you want, but also to ensure youâ€™re able to pay all your debts and live comfortably at the same time.
There are several ways to lower your debt-to-income ratio:
Avoid taking on more debt.
Donâ€™t make any big purchases on credit before you buy a home.
Try to pay off as much of your current debt as possible before you apply for a mortgage.
â€œThe best thing homebuyers can do is pay down or pay off high-interest credit card and consumer debt,â€ says Chris Hiestand, director of marketing at Lenda, an online lending company. â€œDoing this will improve the back-end ratio and will also boost their credit score. DTI ratios actually donâ€™t impact the mortgage interest rate, but credit scores have a big impact on interest rates.â€
While a pay raise at work is another way to lower your DTI, itâ€™s not safe to rely on something that might not happen. Thatâ€™s why itâ€™s better to avoid taking on more debt and work on whittling down the debt you have.
In most cases, lenders wonâ€™t include installment debts like car or student loan payments as part of your DTI if you have just a few months left to pay them off.
If your debt-to-income ratio is exceptionally high â€” say 50% or more â€” you probably should wait on a home purchase.
â€œThereâ€™s nothing wrong with saying, â€˜I need to wait another year before I buy a house,â€™â€ Rheingold says. He suggests getting your finances in order first so that you present yourself as someone with good credit and not a lot of overhanging debt.
Before you sit down with a lender, using aÂ home loan calculatorÂ is one way to figure out how much house you can afford.
The lower your debt-to-income ratio, the safer you are to lenders â€” and the better your finances will be.
Michael Burge is a staff writer at NerdWallet, a personal finance website.Â
The articleÂ Debt-to-Income Ratio Matters When Youâ€™re Buying a HouseÂ originally appeared onÂ NerdWallet.