First-time homebuyers can be overwhelmed with the process of buying a home, with so many terms and concepts that they have never encountered before. One of the essential concepts that every homebuyer should know is the debt-to-income (DTI) ratio, a simple calculation that can make sure you can afford to buy a home. Here’s everything you need to know about DTI ratios, how you can calculate them, and why it’s so important to keep them in check.
What is debt-to-income ratio?
The debt-to-income ratio is a measure of how much of your monthly income goes to paying your debt obligations. It’s a way for lenders to see if you have the ability to repay your debts, including a mortgage, in addition to your other financial obligations.
Debt obligations include any revolving credit payments like credit cards, car loans, personal loans, and any fixed debt payments like rent, mortgage payments, and student loans. The standard recommended DTI ratio is no more than 43% of your income. A DTI ratio under 36% may make it easier to obtain better loan terms and qualify for competitive interest rates.
Why does it matter?
DTI ratio has a significant impact on your overall financial health because lenders use this ratio to determine how much of a mortgage you can afford. In general, high DTI ratios can affect your ability to borrow money, get lower interest rates on loans, and, in some cases, even affect your credit rating. Lenders want to see that you can comfortably manage your debt payments along with your other essential expenses.
How does DTI ratio affect the homebuying process?
When you apply for a home mortgage, lenders review your application and calculate your DTI ratio, so it’s essential to keep an eye on it. If your DTI ratio is high, it might be challenging to get the loan approval you need to buy a home. A high DTI ratio means that you will have less money available to cover all your living expenses and a higher likelihood that you will default on a loan.
Besides the traditional DTI ratio, some lenders may use a front-end and back-end DTI ratio. The front-end ratio considers only your housing expenses (mortgage payment, property taxes, and insurance), while the back-end ratio takes into account all your monthly debt obligations. Lenders might use both ratios to determine if your debt and income levels meet the lender’s guidelines.
It’s important to remember that your DTI is just one factor lenders consider when you apply for a mortgage. They will also look at your employment history, credit score, down payment amount, and other factors. However, understanding your DTI and taking steps to improve it can make a big difference in the mortgage approval process.
How can you calculate your DTI ratio?
Calculating your DTI ratio is simple. You’ll need to add up all of your monthly debt payments, including mortgage or rent, car loans, credit card bills, and student loans. Then, divide that number by your gross monthly income. For example, if your monthly debt payments come to $1,500 and your gross monthly income is $5,000, then your DTI ratio is 30%.
Ways to improve your DTI ratio
If you’re looking to improve your DTI ratio, you have two options: reduce your debt or increase your income. It may take some time, but reducing your debt is a straightforward solution to improving your ratio. Pay off your debts aggressively, starting with the ones with the highest interest rates. Increasing your income through a second job or freelance work also helps.
Understanding your debt-to-income ratio is an essential step when considering buying a house. It’s an indication of your financial stability and your ability to manage your debts. By knowing your DTI ratio, you can plan your finances accordingly and address any potential issues before approaching a lender.
Find a new home with Discovery Homes
We hope you’ll consider Discovery Homes when you’re ready to buy a new home in the San Francisco Bay Area. We build new construction homes throughout the Bay Area that are perfect for families of all sizes. Visit us online at DiscoveryHomes.com to learn more about our new home communities and schedule a visit today!