Debt-to-income (DTI) ratio – what is it and why does it matter?

A borrower’s debt-to-income (DTI) ratio is a formula that compares your monthly debt obligations to your total gross (pre-tax and before any payroll deductions) monthly income. Your DTI ratio is what lenders will evaluate to determine how much of a mortgage they will qualify for. DTI consists of two numbers – a “front-end” ratio and a “back-end” ratio.

Your front-end ratio is simply the monthly payment for your primary residence compared to your gross monthly income. If you are purchasing a home that will be your primary residence, you will use the total monthly mortgage payment (principal, interest, taxes, insurance, and PMI/HOA dues if applicable) for that property when calculating DTI. For example, if your gross monthly income is $8,000 and the mortgage payment on your new home will be $3,000, your front-end DTI ratio will be 37.5% ($3,000 primary housing expense/$8,000 gross income).

Your back-end ratio takes the front-end ratio and tacks on your other monthly debt obligations such as auto loan payments, student loan payments, personal loan payments, and any minimum credit card payments. Typically, only debts that show on your credit report will be added into your back-end DTI, and expenses like cell phone payments, groceries, and gas are not counted. Let’s use the same example listed above, but say you also have a $500/mo auto loan payment, $250/mo in student loan payments, and minimum credit card payments of $150/mo. This adds an additional $900/mo to your total debt obligations, bringing your back-end DTI to 48.75% ($3,900 in total expenses/$8,000 gross income).

In this example, you would have a front-end DTI ratio of 37.5% and a back-end DTI ratio of 48.75%. In mortgage lingo, this would be expressed as a 37.5/48.75 DTI. There are different thresholds for front-end and back-end DTI ratios depending on loan program and credit score.

• • With a strong credit score, your maximum DTI for a conventional loan will be 50/50 (i.e. you may be able to qualify for a mortgage up to 50% of your gross monthly income, or $4,000 in our example, as long as you don’t have any other debt).

• • The maximum DTI for an FHA loan is 46.999/56.999. In our scenario, this would allow you to qualify for a maximum monthly mortgage payment of $3,679/mo (46.999% of your gross monthly income) as long as your total monthly debt obligations, including your mortgage, do not exceed $4,559/mo (56.999% of your gross monthly income).

• • For a VA loan, there is no set DTI threshold, but some lenders may implement a maximum back-end ratio of 41% or 50%. Automated underwriting systems for VA loans utilize DTI as part of the total risk analysis to determine if a loan will be approved, but there is no firm “line in the sand” maximum DTI ratio as there is with conventional and FHA loans.

Your DTI is what determines how much of a mortgage payment you will qualify for, and your maximum mortgage payment is what determines the size of the loan you are eligible for, which ultimately equates to the purchase price you are qualified for. When I am working with clients, I always tell them that there are two numbers – the monthly payment they qualify for and the monthly payment they are comfortable with. If you qualify for a $4,000/mo mortgage payment, but you aren’t comfortable budgeting for more than $3,500/mo, start your home search in the price range that will give you the lower payment, but know that you do have the ability to go up in price if you find that dream home.

On the other hand, sometimes the inverse happens – where you speak with a lender, and they tell you that you are pre-approved for an amount that is less than what you’d hoped for. For example, maybe you are planning to put 5% down on a home, and your lender tells you that based on your DTI you’re qualified for a $700,000 home. However, to get into a home that is suitable for your family’s needs, you really need to be in the $750,000 – $800,000 range. If this happens, there are still several things you may be able to do to qualify for a higher amount. A few common strategies to lower your DTI are increasing your down payment, adding a co-borrower who can supply extra income to the loan, paying points to obtain a lower interest rate and payment, or paying off other debts at closing to lower your back-end DTI.

Keep in mind that some lenders have requirements that are more restrictive (called overlays) than others, so if you speak with three different loan officers, you may get three different pre-approval amounts. At Solcosta Home Loans, we are an independently owned mortgage brokerage with access to multiple lenders. This gives us (and you) options and allows us to match you with the loan that is perfectly suited for your individual needs.

If you are interested in getting pre-approved to purchase a home or you’re interested in refinancing your existing loan, the first step would be completing our user-friendly online application here. Not quite ready to apply, but want to chat through your situation and options? That works for us! Click here to schedule a free 15-minute call with our broker/owner, Dan Patty, or email us at TeamDan@solcostahomeloans.com. We look forward to hearing from you!