Imagine you’re a lender, and a wellness entrepreneur comes to you to borrow thousands or hundreds of thousands of dollars. The loan seeker is the picture of health, drives a Tesla S, and lives in a solar-powered manse. But what if the would-be borrower is overextended, and not in a yoga-like way?
You’re going to want to compare their current income to their debts to help gauge how likely you are to be paid back.
Makes sense, right? A debt-to-income ratio helps to determine whether someone qualifies for a loan, credit card, or line of credit and at what interest rate.
A low DTI ratio demonstrates that there is probably sufficient income to pay debts and take on more. But what’s “low” or “good” in most lenders’ eyes?
First, a Debt to Income Ratio Refresher
In case you don’t know how to calculate the percentage or have forgotten, here’s how it works:
DTI = monthly debts / gross monthly income
Let’s say monthly debt payments are as follows:
• Auto loan: $400
• Student loans: $300
• Credit cards: $300
• Mortgage payment: $1,300
That’s $2,300 in monthly obligations. Now let’s say gross monthly income is $7,000.
$2,300 / $7,000 = 0.328
Multiply the result by 100 for a DTI ratio of nearly 33%, meaning 33% of this person’s gross monthly income goes toward debt repayment.
What Is Considered a Good DTI?
The federal Consumer Financial Protection Bureau advises homeowners to consider maintaining a DTI ratio of 36% or less and for renters to consider keeping a DTI ratio of 15% to 20% or less (rent is not included in this ratio).
In general, mortgage lenders like to see a DTI ratio of no more than 36%, though that is not necessarily the maximum.
For instance, DTI limits can change based on whether or not you are considering a qualified or nonqualified mortgage. A qualified mortgage is a home loan with more stable features and without risky features like interest-only payments. Qualified mortgages limit how high your DTI ratio can be.
A nonqualified mortgage loan is not inherently high-risk or subprime. It is simply a loan that doesn’t fit into the complex rules associated with a qualified mortgage.
Nonqualified mortgages can be helpful for borrowers in unusual circumstances, such as having been self-employed for less than two years. A lender may make an exception if you have a high DTI ratio as long as, for example, you have a lot of cash reserves.
In general, borrowers looking for a qualified mortgage can expect lenders to require a DTI of 43% or less.
Under certain criteria, a maximum allowable DTI ratio can be as high as 50%. Fannie Mae’s maximum DTI ratio is 36% for manually underwritten loans, but the affordable-lending promoter will allow a 45% DTI ratio if a borrower meets credit score and reserve requirements, and up to 50% for loans issued through automated underwriting.
In the market for a personal loan? Some lenders may allow a high DTI ratio because a common use of personal loans is credit card debt consolidation. But most lenders will want to be sure that you are gainfully employed and have sufficient income to repay the loan.
Front End vs Back End
Some mortgage lenders like to break a number into front-end and back-end DTI (28/36, for instance). The top number represents the front-end ratio, and the bottom number is the back-end ratio.
A front-end ratio, also known as the housing ratio, takes into account housing costs or potential housing costs.
A back-end ratio is more comprehensive. It includes all current recurring debt payments and housing expenses.
Lenders typically look for a front-end ratio of 28% tops, and a back-end ratio no higher than 36%, though they may accept higher ratios if a credit score, savings, and down payment are robust.
How Can I Lower My Debt-to-Income Ratio?
So what do you do if the number you’ve calculated isn’t your ideal? There are two ways to lower your DTI ratio: Increase your income or decrease your debt.
Working overtime, starting a side hustle, getting a new job, or asking for a raise are all good options to boost income.
Strangely enough, if you choose to tackle your debt by only increasing your payments each month, it can have a negative effect on your DTI ratio. Instead, it can be a good idea to consider ways to reduce your outstanding debt altogether.
The best-known debt management plans are likely the snowball and avalanche methods, but there’s also the fireball method, which combines both strategies.
Instead of canceling a credit card, it might be better to cut it up or hide it. In the world of credit, established credit in good standing is looked upon more favorably than new.
The Takeaway
Your debt-to-income ratio matters because it affects your ability to borrow money and the interest rate for doing so. In general, lenders look at a lower DTI ratio as favorable, but sometimes there’s wiggle room.
If you’re struggling with student loan debt, refinancing might be a good option if you can lower your interest rate. And if you’re trying to pay off high-interest credit card debt, one method is to consolidate the debt with a fixed-rate personal loan. This can lower your monthly payment, thus changing your DTI ratio.
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