If you are in the market for a mortgage, one of the first things lenders will look at is your debt-to-income ratio. If the ratio is too high, you will struggle to get the rate you want or even be approved at all. There is no reason to take any chances, know your debt-to-income and take steps to keep it at a healthy level. Therefore, I am going to give you some approaches to improving your debt-to-income ratio.
What is Your Debt-to-income Ratio?
Your debt-to-income ratio is a personal finance measurement that compares your debt to your income and used together with other indicators to determine your ability to pay debt back. This is especially important when you are making a mortgage application. Your debt-to-income ratio is calculated by dividing your total monthly debt payments by your gross monthly income (pre-tax income). This is usually written as a percentage.
To better illustrate the point lets look at the monthly outgoings of a friend of mine. He pays $1,250 for his housing payment (this includes mortgage, PMI, and taxes). A $500 car payment. A $400 credit card payment, another $200 dollar car payment and a $350 student loan payment. That adds up to a grand total of $2,700 a month. His gross monthly income is $4,500. So, what we do is $2,700/$4,500, or 60%.
Having a debt-to-income ratio of 59 percent is high. My friend would probably have a hard time getting any kind of finance without changing anything. Improving this ratio means that you must do a few things. You can increase your income, pay off debts or refinance existing debt with a lower monthly payment.
Increasing Income and Paying off Debts
Increasing your income is a great way to reduce the ratio. If we look at the numbers, if my friend managed to increase his income to $5,500 a month then the ratio, with the same outgoings, would look more like 49% ($2700/$5,550=0.490909090…).
But if increasingly your soon is not an easy option for you. Then you should consider reducing your debt. If my friend paid off his car loans, then he would have less debt and a better ratio.
But here is the catch: DTI is based on your monthly debt payments, not the total amount of debt. That means if you make extra payments on a car loan, for example, you are reducing the outstanding balance, but your monthly payments stay the same and so does your debt-to-income ratio.
If you currently have high credit card balances, making additional monthly payments will improve your debt-to-income ratio because the minimum monthly credit card payments are calculated as a percentage of the outstanding balance. Conversely, if you increase your debt or your income is lowered for whatever reason, your ratio will go up.
You could be able to reduce your student loan payments by refinancing at a lower interest rate or by increasing the number of years over which you repay the loan. This will give you more breathing room to also further increase payments because stretching out monthly payments further generally costs less each month. Remember though, lower interest rates are a good thing, we do not recommend refinancing to extend the amount of time it will take you to pay off a debt. But there are situations where it can help you out. Everyone’s financial situation is different.
Ironically, however, this decision might enable you to get approved for a mortgage when you otherwise could not. This is because the bank only cares about the monthly debt.
To summarize, if you are looking for a mortgage understanding where you are at with your debt-to-income ratio is critical to improving your odds of being approved for the loan that has the right terms for you. Otherwise you will limit yourself to poor terms or no mortgage at all. Make sure to pay off as much as you can as soon as you can. Refinancing where you can for lower interest rates is a smart move too.