A major factor that mortgage lenders will review when evaluating whether you qualify for a loan is your Debt-to-Income Ratio (DTI).
As the name implies, your DTI is a factor of how much debt you pay compared to how much income you make. Its determined on a monthly basis.
More specifically, DTI calculates how much of your gross monthly income goes toward your minimum monthly debt payments. Debts include mortgages, home equity lines of credit, student loans, auto loans, credit cards, and the like. Child support or alimony are also included.
DTI only considers the amount of your income spent on debt payments, and not on basic living expenses such as utilities, cell phone service, groceries, or your Netflix subscription.
DTI is expressed as a percentage, such as 34%. And it is a ratio in which lower is better, as a low DTI indicates that you have sufficiently more income than debt payments each month.
Here’s an example of how DTI is calculated.
First, add up all the monthly minimum debt payments:
Mortgage or Rent $ 1,250
Auto Loan $ 450
Student Loan $ 385
Credit Card $ 80
Total $ 2,165
Note when calculating DTI, mortgage payments include the principle and interest payments, as well as taxes, homeowner’s insurance, mortgage insurance (PMI), and any homeowner’s association (HOA) dues.
Next, determine your gross monthly income. If you’re salaried, then you can simply divide your annual salary by 12 months. If your income changes from month to month due to hourly pay, commissions, side jobs, or other reasons, then you should use the most recent month’s pay stubs to determine your monthly income.
Let’s assume a Gross Monthly Income is $4,825.
Finally, divide the total monthly debt payments by your gross monthly income. Convert the result to a percentage by multiplying it times 100.
2,165 / 4,825 = .448
.448 X 100 = 44.8%
In our example, the DTI ratio is approximately 45%.
A high DTI means that a substantial amount of your gross monthly income is already being used to pay on existing debts. In this case, a lender will be concerned that you may not have enough left over to fully pay on any new loans, and as such, would consider you high-risk as a borrower.
While different lenders have different standards, most generally consider a good DTI to be below 36% overall, with no more than 28% going toward mortgage payments.
When considering new loans for investment purposes, real estate investors should always talk to lenders specifically about what is considered an acceptable DTI, and what types of income are factored into the DTI calculation. For example, lenders will typically count 75% of all rental income toward your gross income amount for DTI purposes.
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