Most people know how important your credit score is for getting loans and renting an apartment, but when it comes to applying for a mortgage, lenders put more emphasis on your debt-to-income ratio.
Learning about the debt-to-income ratio and how it’s calculated will help you during the mortgage application process. Find out what’s involved and what lenders are looking for before you start the process. In this guide, you’ll also learn to make your own debt-to-income ratio worksheet and how to improve your debt-to-income ratio if it’s on the high end.
What Is Debt-to-Income Ratio?
Debt-to-income ratio compares your existing debt payments with your income to see if mortgage payments are within your current financial capacity. It’s a straightforward calculation that looks at how much of your gross monthly income goes toward servicing debt, including mortgage and loan payments, credit card minimums, and payments toward your personal credit line. What lenders want to know is how much of your income is already committed to fixed payments, and whether your income is enough to add on mortgage payments.
Why Debt-to-Income Ratio Is More Important Than Credit Score
Your credit score is a record of your credit history. It shows whether you’ve paid your bills on time in the past and how consistently you’ve made payments on credit cards and lines of credit. While this information is important, it’s more critical for lenders to know that you’ll be able to pay your debts in the future, given your recurring payments and your income.
That’s where debt-to-income ratio comes in; it shows how much of your income will go toward fixed payments if you take on a mortgage of X amount at rate Y. That gives lenders a good idea of whether you’ll be able to comfortably afford the mortgage you’re applying for.
Types of Income to Debt Ratio for Mortgage Loan Evaluations
Lenders use two types of debt-to-income ratios for the mortgage approval process:
- Front-end ratio (Housing Ratio): This ratio measures only your housing-related expenses, including your proposed mortgage payment, property taxes, homeowners’ insurance, and HOA fees if applicable. Most lenders prefer that this total stay below 28% of your gross monthly income.
- Back-end ratio (Total Debt-To-Income Ratio): This is a more comprehensive metric that includes all your monthly debt obligations, including your housing expenses plus loan payments, credit card minimums, and all other recurring debt payments, as a percentage of your gross monthly income.
When lenders refer to debt-to-income ratio, they’re usually talking about the total (back-end) debt-to-income ratio. That’s the more important number for them.
What Debt-to-Income Ratio Is Required for a Mortgage?
Debt-to-income ratio requirements vary by lender, and the ultimate decisions will depend on other aspects of your financial profile and employment profile. Here are some general standards:
- Conventional loans: lenders prefer a back-end debt-to-income ratio of 43% or lower, although some will approve borrowers with ratios of up to 50% if they have significant savings and a strong credit score.
- FHA Loans: Similar to conventional loans, FHA loans look for a debt-to-income ratio under 43%, but will allow up to 50% if the borrower has other compensating factors.
- VA Loans generally allow a debt-to-income ratio of up to 41%, but they do have some flexibility.
- USDA loans look for a debt-to-income ratio of 41% or less.
Note that these are general guidelines rather than absolute rules. Some lenders have regulatory limits they have to abide by, but others have more discretion.
How to Calculate Your Debt-to-Income Ratio
You can use an online debt-to-income ratio for a mortgage loan calculator, but it’s not difficult to do the calculation by hand.
Start by collecting this information:
- Gross monthly income
- Salary, wages, and self-employment income
- Commission-based income and bonuses (requires 2 years of documented history)
- Social security, pension, or retirement income
- Disability benefits
- VA benefits
- Child support and spousal support that you receive
- Trust and investment income, annuity payments
- Rental income on investment properties after subtracting mortgage payments
- Monthly housing costs
- Projected principal and interest
- Property taxes
- Homeowner’s insurance, flood insurance for homes in flood zones, mortgage insurance for FHA loans, PMI (if required)
- HOA fees
- Do not include utilities, heating costs, cable, or internet
- Monthly debt obligations
- Credit card minimum payments on the most recent statement
- Car, student, and personal loans
- Child or spousal support that you pay
- Line of credit minimum payments
- Medical payment plans and IRS payment plans
- 401 (k) loans if paid through payroll deductions
Add your income sources for a year and divide by 12 to get your monthly gross income. Then divide your monthly debt obligations by your gross monthly income and multiply by 100 to get a percentage. For example, if you have $1,800 in monthly debt payments, and you earn $6,500 per month before taxes, your debt-to-income ratio would be ($1,800 ÷ $6,500) X 100 = 27.7%
Use the categories of income and debt obligations above to set up a debt-to-income ratio worksheet (many lenders also provide their own). Maintaining this worksheet will help you see your complete financial picture and understand how small improvements could change your profile.
Using a Debt-to-Income Ratio for Mortgage Loan Calculator
Manual calculations usually work well, but an online debt-to-income ratio for a mortgage loan calculator offers convenience and added functions. For example, some tools will show you how your debt-to-income ratio lines up with requirements for different loan types. You can also reverse your calculations by entering your desired debt-to-income ratio to determine how large a mortgage you could qualify for.
Most major bank websites and mortgage broker platforms offer an online calculator to help you estimate your debt-to-income ratio. Try one to see how adjusting your income or debt obligations can change your mortgage qualification amount.
How to Improve Your Debt-to-Income Ratio
If your debt-to-income ratio is too high for the loan you want, you can work to improve it. Here are some key strategies:
- Pay down or pay off existing debts. Even reducing your monthly debt obligations by $200 or $300 can make a meaningful difference.
- Increase your income. If you plan to do this by taking on part-time work, keep in mind that you’ll need two years of this income for it to count toward your debt-to-income ratio.
- Avoid new debt, including new loans and credit cards.
- Request payment reductions from creditors to lower your monthly debt payments.
- Postpone major purchases such as new cars.
- Consider a home outside your preferred area, a smaller home, or one that needs improvements (taking the cost of the renovations into account).
You might also want to consider a consolidation loan if you have a lot of different credit card balances or high-interest loans. Be careful with timing, as getting a consolidation loan can affect your credit score.
Debt-to-income Ratio and Credit Score Work Together
Although we’ve emphasized debt-to-income ratio as a determining factor in getting the mortgage you want, your credit score still plays a role. The ideal applicant has both a strong credit score and a good debt-to-income ratio. Working with a mortgage professional or financial planner can be extremely helpful in clarifying your financial and home-buying goals and getting you into the home you want.
