The Debt-to-Income Ratio (DTI) is an important ratio that helps a bank in determining whether you are credit-worthy (worthy of giving a loan) or not. It is not the only thing that determines, but if it is not up to snuff, you might find yourself out of a loan without the bank ever having looked at any other reason to lend to you.
It’s a Ratio
Remember, ratios are something divided by another thing. They tell us how much one thing is of another thing. DTI is how much debt you have as a percentage of your income. Because it is a ratio, the time period doesn’t matter. You could calculate it monthly or annually.
This is the total amount of money you pay to various lenders. It is not how much you owe, just how much you pay. This can be other mortgages, rent, car loans, credit card debt, or some kind of other obligation. The bank is first going to ask you for a list of your debts and income. This shows up on a thing called the Personal Financial Statement (PFS), something we will talk about later. In a nutshell, the PFS is your listing of all your debts and income.
The bank might also ask for a Debt Schedule, another listing of all your debts, when you pay them, and when they mature (get paid off).
Next, the bank will run a credit check and most of your debts will be present there. This better match up with what you reported earlier or you will have some questions to answer. The debt is the total amount you pay over the time period.
This is the total amount of income you make in the time period. This can be from any source for the purposes of DTI, but the bank will look at temporary income less favorably than what the bank assumes is stronger, such as W2 income, from your job.
DTI = (Debt / Income )
Thus, if you have an annual income of $400,000 and annual debt payments of $100,000 your DTI will be 0.25, or 25%.
What is a Good DTI?
Good would be 0%, having no debt at all. That would be strange, as most people do have some amount of debt, though. Banks would like your DTI to be 35% or less ideally. Getting up to mid-40s% starts to look like you might have trouble paying off your new loan should anything in your life change and income decrease.
How Do I Decrease My DTI?
There are only two ways: Increase your income or restructure debt. The best way is to pay off the debt, but you might be able to refinance it.
Keep in mind that the DTI is only one area that the bank will look. If you have a lot of low interest rate loans, your DTI might be low, but your total debt is still high. This will be looked at unfavorably.
Make sure you know your DTI before going after a loan. If it is low, then go for it. If it is high start thinking of ways to decrease it or explain it so you are prepared for your next mortgage ask.