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What is DTI Ratio?

If you're brand new to the homebuying experience or already have some familiarity with the in's and out's of real estate, you know that this industry has a bevy of abbreviations. From FRM (fixed-rate mortgage) to FMV (fair market value) or HUD (Housing and Urban Development) to NAR (National Association of Realtors), were housing to have a favorite food, alphabet soup would likely be its dish of choice.

Here's another three-letter initialism you've probably heard of but may not know exactly what it means: DTI. Short for debt-to-income ratio, DTI is something that your lender assesses when you first apply for a mortgage. It's a mathematical equation that helps your mortgage provider determine where you are financially in terms of the ongoing costs you have now and how much of your incoming income is devoted to making payments on outstanding debt.

As you might imagine, there's a little bit more to it than that. For example, how do you calculate your DTI ratio? What's considered a "good" debt-to-income ratio? What payments are evaluated in this mathematical equation? What's the difference between back-end and front-end DTI?

You're about to find out about this and much more, which can help you better prepare for the early steps involved along the path to homeownership:

What does my DTI ratio establish and how do I figure out mine?

As previously referenced, your DTI ratio is a numerical way of identifying what percentage of your monthly salary is going toward debt. Whenever you hear this four-letter word invoked, it's often in a negative context. But debt isn't necessarily a bad thing: Virtually everyone has at least some of it in one form or another to pay for certain goods, possessions or services experienced at various stages of life. In fact, paying off debt on a regular basis helps to improve your credit standing.  

It's too much debt that's the problem. DTI ratio enables your lender to see how much - or how little - you currently have. It's calculated like this:

  • Monthly payments ÷ gross monthly income = DTI ratio

"Monthly payments" is a pretty broad term and will likely vary considerably depending on your situation and age. For instance, if you recently graduated from college, you may still have college loans to pay off or auto payments. If these are costs you currently have, they're used to determine your DTI.

Consider this example, let's say you're paying $1,000 month in student loans and around $350 for that new car you bought. That equals out to be $1,350. 

Once you divide this total by your pre-tax income - say, $4,000 per month -  and then multiplying the total by 100, you get a percentage of 37.5%.

These aren't the only two payments taken into consideration, of course. Other monthly debts evaluated - if you have them - include credit card payments or installment loans. 

It's also worth mentioning the expenses that are not included in determining your DTI. These include rent, medical bills, utility expenses, telephone and cable bills or groceries. Since these cost considerations don't appear on your credit report, they're not used for DTI ratio calculations. 

What's considered a good DTI ratio?

There aren't many absolutes when it comes to applying for a house. Because each person is different, what's considered a "good" ratio for you may be "needs work" for another. The ultimate answer depends on the circumstances of the moment, such as the house in consideration, the terms of the loan and other personal factors. 

That said, the ideal range is between 28% and 43%. Using the above example, a DTI ratio of 37.5% means that slightly more than a third of a prospective borrower's earnings are servicing debt. As noted by the Consumer Federal Protection Bureau, the debt to income ratio should ideally be no higher than 43%, as studies have shown those who devote more than this percentage of their earnings to ongoing debt frequently encounter issues with paying off their expenses. But again, when its evaluated in consultation with your other financials, certain exceptions may apply. 

What's the difference between back-end ratio and front-end ratio?

There are two ways of examining your DTI: front-end and back-end. Both are after the same goal of determining how much of your income goes to certain payments. It's the number of "ingredients," if you will, that's slightly different. The former takes into account things like credit card debt and installment loans, such as if you're making car payments or have a personal loan out.

The latter evaluates these expenses along with your prospective monthly mortgage payment. It's possible - in fact, likely - that your front-end ratio total will be different from your back-end. Neither one is necessarily more important than the other. This is just another way of examining your financial situation so your lender can get a better idea of your current situation to put you in the best position possible moving forward.

How do you go about reducing your DTI ratio?

Of course, the best type of DTI ratio is a low one. But if yours is a bit high, you may be wondering how to cut it down a bit. Here are a few creative strategies, as suggested by Credit.com. 

Prioritize your payments

Just as types of bills run the gamut, so do the ways in which you can prioritize them. For example, some financial advisors recommend paying down the one with the highest bill-to-balance ratio. Here, you concentrate, not necessarily on the total amount owed, but the degree to which you're reducing debt in combination with what your spending. That means that if one monthly payment reduces the balance by 35% and the other cuts it down by 20% or 25%, prioritize the first payment as opposed to the second.

Other experts say it's best to pay down the bill with the highest interest rate first. This strategy will save you money, as you’ll spend less on interest over time.

Then again, it may be a better choice to pay off the balance that's the smallest first, as paying it off completely provides a sense of accomplishment, giving you motivation to continue paying off debts. 

Another strategy is to pay off your credit cards first. This not only decreases your DTI, but also can help to increase your credit score if you are able to decrease your credit card debt to below 30% of the maximum available credit.

The key to success in reducing debt  is knowing what works best for you. Practicing some self-reflection will help you with prioritization. This way, you'll get the most balance-slashing bang for your bill-spending buck.  

Pay off your bills before they’re due

For installment loans like car loans, monthly statements typically feature at least three components: the monthly balance owed, how much still remains to be paid and the bill's due date. Instead of paying the prescribed amount, though, you may want to consider spending a bit more if your budget allows for it. For instance, if you earn a commission and earned a higher dollar figure than is typical, consider devoting the difference - or a portion of it - to your next monthly payment. This will help you pay the debt off ahead of schedule and potentially pay less money in interest in the process.

Ask for a raise

According to a recent poll conducted by staffing agency Robert Half, approximately 50% of full-time working adults in America believe they're underpaid. If you consider yourself one of them, consider asking for a bump in pay. As noted by Credit.com, as it pertains to DTI ratio, people often get caught up on how much they owe. But the "I" in DTI is every bit as important as D. Thus, if your monthly income is $4,000 per month before taxes and after a raise it's increased to $5,000, your DTI ratio will naturally lower, assuming that your debts remain unchanged. Actually receiving a salary increase is easier said than done, but you can state your case by demonstrating why you're an asset to your employer by pointing to previous accomplishments or contributions.

Think about refinancing

The interest rate environment is in a near constant state of flux, but one thing is certain: Rates have remained low for many years. You may want to refinance with your lender if you're still paying off student debt or a car loan. Your credit situation may have improved since you first took out the loan, which could make you eligible for a rate adjustment. 

Your DTI ratio is one portion of the mortgage approval puzzle. RMS can help you put all of the pieces together so you can see the big picture. Contact us and we'll be happy to assist you in coming up with a solution.