Prospective home buyers across the country understand that they have to watch their finances closely in order to afford a home. When it comes to the home buying process, one little known metric is oftentimes more important than even the amount of money you make.
Your debt-to-income ratio (DTI) will be used by your mortgage lender to assess your financial standing and decide whether or not your mortgage application will be approved.
I'm back today to talk about DTI ratios and to provide you with a worksheet that will calculate your own DTI ratio.
Our debt-to-income ratio worksheet
Our DTI worksheet will help you to:
Calculate your current DTI ratio
Learn whether you are likely to secure home financing
Provide your insight on how to optimize your ratio
How to use the debt-to-income ratio worksheet
Using this worksheet is really easy to do! Once you have your copy (just provide us your email above to be immediately redirected), just answer the questions that you see above.
It will ask you for your:
Monthly income: Monthly pre-tax income
Student loan payments: Monthly student loan payments
Credit card debt payments: Credit card debt payments
Car payments: Monthly car bill
Existing mortgage payments: Home loan payments on existing home
Medical debt payments: Use if you have medical debt
Other debt payments: Any other debt you make payments on
Then, the worksheet will calculate your DTI for you!
What is a debt-to-income ratio?
A debt-to-income (DTI) ratio is equal to your monthly debt payments and obligations divided by your gross monthly income. The ratio, usually reflected as a percentage, represents what percentage of your monthly income goes to servicing your debt.
Since your home's mortgage is likely to become your largest source of debt, calculating this ratio, both before and after the extension of home financing, is a critical part of many lenders' underwriting or mortgage approval processes.
As a result, your DTI ratio is considered a great metric to evaluate your creditworthiness and ability to repay your home loan.
All this said, it is generally advisable to maintain as low a DTI ratio as possible.
What is a good DTI ratio?
How to calculate your debt-to-income ratio
Calculating your DTI ratio isn't hard to do, but it can be manual. This is where my worksheet can save you time and effort. But in case you're looking to calculate your DTI manually, here is the formula to use:
DTI ratio = (Your total monthly debt payments / Monthly pre-tax income) * 100
Let's run through an example. Assume that someone looking to buy a home has:
A monthly car bill of $400
$500 in student loan payments
A monthly pre-tax income of $6,000
Using the above formula, this person would have a DTI ratio of 15%.
What is a good debt-to-income ratio?
Different mortgage lenders have different underwriting and mortgage application criteria, but generally, those looking to purchase a home with a Conventional mortgage will want to have a DTI below, and ideally well below, 43%.
In some instances, certain lenders may be willing to extend home financing to those with higher DTI ratios. This is more so the exception than the rule, but those with high credit scores and cash reserves stand the best chance of being approved.
Other career focused mortgage programs, such as those for doctors and lawyers, also are meant to provide flexibility for those working in fields where high levels of student loan debt are common.
After you've filled in the corresponding values to these questions (you can leave blank any line items or debts that don't apply to you, you'll notice that your debt-to-income ratio at the bottom of the screen will automatically update.
Remember - you'll likely need a DTI ratio of 43% of under to qualify for a mortgage loan, but typically, I recommend that you hold off on buying a home until your ratio has come down to the 30-35% range, counting your new home loan.
Not only will you become a better qualified borrower, but you'll also have more wiggle room in your monthly and annual cash flow in the event that you lose your job or encounter any large expenses.
How to lower your DTI ratio
If you know that you've got more debt than you should, you'll want to do what you can to lower your debt-to-income ratio as quickly as possible. Luckily, there is no shortage of strategies out there to help you do just this.
Most other websites and bloggers will simply provide you with a list of suggestions about paying down debt. And while this can be a great start, it also fails to consider that growing your income can be another great way to improve your DTI.
With this in mind, I think that the most effective strategies include:
Aggressively pay down debt
Do not apply for any new loans
Pick up a side hustle
1. Aggressively pay down debt
As I've already alluded to, your best approach to building a more attractive profile as a borrower is to aggressively pay down what debt you do have.
Of course, this process is easier said than done, and it will take some time, but the earlier you start, the better.
Not all debt is created equally
I do encourage you to consider that not all debt is considered equally. For instance, depending on how much debt you have, student loans will likely be seen in a better light than consumer or credit card debt is. This is particularly true in the event that you're pursuing a special home financing arrangement as a doctor, lawyer, or other type of qualifying professional.
With this in mind, I recommend that you start by paying down your consumer debt first if that makes sense financially for you.
The good(?) news is that consumer debt(s) tend to carry the highest interest rates, anyway, making them a good place to start anyway.
Debt avalanche vs. debt snowball
As you look to improve your debt-to-income-ratio, one strategy that may help you be successful in eliminating debt is to consider the debt avalanche and snowball methods.
The avalanche method is a strategy that suggests that it makes the most financial sense to pay down your highest interest debt first, after making all of your minimum payments in a month. The premise here is that your highest interest debt will be the most challenging to eliminate, but once you do, the entire process will continue to build momentum, just like pushing a snowball downhill.
For those that will need a little bit of time to get started, the snowball method may be more advantageous, where you'll start by paying your loans in ascending order by balance. And while the second half of your debt repayment is likely to take longer than the first half, the thought process is that scoring a number of "early wins" can be a great way to start building a series of wins.
2. Do not apply for any new loans
This may go without saying, but you'll want to avoid applying for new loans and credit cards in the meantime. Doing so will not only hit your credit report, but it will also adversely impact your DTI ratio as well.
I'd also recommend that you do whatever you can to keep your credit utilization ratio on your existing credit accounts as low as possible for a period of time.
3. Build new sources of income
You may also have luck by growing your income. Not only does having multiple income streams make you a safer borrower in the eyes of lenders, but boosting your income can be an excellent way to lower your debt-to-income ratio, even if you don't necessarily use your extra income to pay off any debt.
Should you pay off debt with your side hustle proceeds, you'll make progress twice as fast!
Side hustles to consider
There is no shortage of side hustle strategies for you to consider. Among my favorite easy ways to make a few extra dollars include:
Of course, the last two strategies on this list will require an upfront investment, which should never require you to take on any new debt. If you're looking for more strategies with little or no upfront investment or associated costs, I recommend that you consider:
Passive income streams to build
You may also explore ways in which you can optimize your debt-to-income ratio by building out passive income streams. These will likely take more time and effort for you to build and get started, but once you do, you may be able to collect passive income for the foreseeable future, and potentially the rest of your life!
As a blogger, I am biased, but I recommend that you consider starting a blog complete with Google AdSense and affiliate marketing capabilities.
When done correctly, you'll be able to build a revenue stream from each piece of content that you write! In 2023, there is no shortage of topics to write about, including lifestyle, travel, home and garden, fashion, money, and many more!
Plus, it'll help you work towards homeownership!
Does your DTI ratio impact your credit score?
Since your DTI ratio is so important to mortgage and other types of lenders, you're probably wondering what the relationship is between your DTI and credit score.
The answer: DTI ratios do not directly impact your credit score. However, one component of the credit score calculation - your utilization - does impact your credit score, in a calculation known as your debt-to-credit ratio.
Now, I want to hear from you. What is your debt-to-income ratio? And have you successfully lowered it to become a more attractive borrower?
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