Unless your last name is Trump or you were recently the last “Survivor” in Somoa, you’ll probably need a mortgage to purchase a home. Not many folks can afford to pay cash for a more than $100,000 purchase. But to get a mortgage, you have to prove that you can actually pay it off. And that means your lender will be looking at something called DTI or debt to income ratio.
Fortunately, this little calculation is pretty darned simple. Let’s see if you can figure it out on your own with these questions:
1. What is your debt?
2. What is your income?
3. What is a ratio?
Of course, there are many ways to describe your debt (housing, housing + other debts) and many ways to describe your income (gross yearly, take-home monthly). But ratio? That’s simple.
A ratio is a way to compare two numbers, either by using a colon or a fraction. In this case, we’re looking for a number, so we’ll write the debt to income ratio as a fraction and then divide. But how do you know which is the numerator and which is the denominator?
Turns out that’s pretty simple, too. Look at the order: debt comes first, so it will be in the numerator; income comes second, so it will be the denominator. If you think of “to” as the fraction bar (or as division), this makes sense.
debt to income =
You can’t get much easier than division, especially if you can use a calculator. But in order to divide, you need to define your variables. In other words, you need to know what “debt” means and what “income” means.
In this situation, income is your monthly gross income. If you get a weekly paycheck, you’ll have to multiply that amount by four. If you paid twice each month, multiply by two. And if you get paid once each month, you don’t have to do a thing.
The debt can be calculated one of two ways. Some lenders only want to know what your expected housing debt is. This amount will include your monthly mortgage payment, insurance and taxes But these days, lenders are looking at your entire debt, which also includes monthly payments for child support, student loans, car loans and minimum credit card payments — plus your expected housing debt. (You don’t need to include regular monthly bills like energy and childcare costs.)
Let’s say your monthly gross income is $3,027. You’ve figured out that you can afford an $890-per-month housing payment (to include mortgage, insurance and taxes). In addition, you have the following regular monthly debts: minimum monthly credit card payments ($35), student loan payments ($150) and car payment ($300). What is your debt-to-income ratio?
Method One: Simply divide your expected monthly housing expenses by your monthly gross income.
890 ÷ 3027 = 0.29
So using the first method, your debt-to-income ratio is 29%.
Method Two: Add all of your monthly debts and then divide by your gross income.
890 + 35 + 150 + 300 = 1375
1375 ÷ 3027 = 0.45
Looking at all of your monthly debt payments, your debt-to-income ratio is 45%.
But what does this mean? In short, these numbers spell danger. Anyone with a 40-49% DTI is not doing well financially. (Over 50% is considered “living dangerously.“) Most lenders like to see no more than 28% of your monthly debt going to housing costs (mortgage, insurance and taxes), and no more than 36% DTI over all.
If the above scenario were real, it’s very likely you would not be offered a mortgage. (And if you were, run in the other direction. You probably don’t want that kind of debt.) The goal, of course, is to get your DTI as close to 0% as possible. But anything below 28% for housing only and 36% for all debt is within reason.
What’s your DTI? Are you surprised by this amount? How can you reduce it? Feel free to respond in the comments section.