While applying for a home mortgage loan or a car loan, how do you know how much loan you can afford? What are the factors that the lenders take into account? Apart from your three-digit credit score, there is yet another often-forgotten number that is always checked by your lenders, especially your mortgage lender. This is your DTI ratio or the debt-to-income ratio. This is a critical measurement that is used by the loan underwriters to determine your ability to repay the loan on time. Given the importance to the lending decision, it is vital to understand the debt-to-income ratio and what you can do to improve it.
Understanding your DTI ratio – What is it?
Everyone actually has two debt-to-income ratios that all lenders use to determine whether or not you can afford a new mortgage or any new loan. The first kind is what is known as the housing ratio or the front-end ratio. The housing ratio is your proposed total housing payment in a month (including the property taxes, insurance and the monthly mortgage payment) divided by your gross monthly income. The other ratio is known as the total debt-to-income ratio which factors in other monthly financial obligations like student loans, car loan payments, apart from your housing payment.
An acceptable debt-to-income ratio – What is it?
Most lenders don’t have any maximum debt-to-income ratios per se but there are rather guidelines that offer some kind of flexibility. Generally, lenders want to see monthly housing income ratio not more than 28%-33% of your income and total debt not more than 38% of your income. Lenders will only exceed these guidelines when there are sufficient offsetting factors like excellent credit score, larger than required down payment or demonstrated ability to make timely payments every month. Keep in mind that the farther you surpass, the stronger your offsetting factors will need to be.
Ways to keep improving your DTI ratio and be a favourite among lenders
In order to determine your ideal DTI ratio, simply multiply your monthly income by .36 and the resulting amount is the maximum that you should be spending on credit cards, mortgage loans, student loans and other financial obligations. If your payments fall below that number, this means that you are in incredibly good financial shape. There are things you can do to improve your DTI ratio. Here are some of them.
- Start living within your means: Caviar dreams on a beer and hot dog budget can spell financial disaster if you act on them. If you wish to be financially sound, you should live within your means and save up for items and events that are scheduled to take place on a later date. Always remember that the secret to living a debt free life is to live within your means. Your expenses should always be beyond your income so that there’s always something left for your savings account and emergency fund.
- Adjust your expenses according to your income: Someone who has been recently unemployed will certainly learn a lesson about adjusting his expenses. When you were employed, your expenses were certainly more but once you lose your job, you will tend to adjust your expenses and your lifestyle that pays less than what you were accustomed to. In case your income has dropped suddenly due to some unavoidable reason, you should cut down on some expenses so as to maintain a low Debt-to-Income ratio.
- Pay down your credit card debt: Indeed, the fastest way to reduce your debt-to-income ratio is to pay it down as soon as possible and decrease the ratio in accordance with your income. There are different ways of paying off your credit card debt among which some are seeking help of credit counseling agencies, taking out debt consolidation loans and signing up with a debt consolidation company. You can even take some DIY steps like adopting the debt avalanche or the debt snowball method in accordance with your current financial situation.
- Save more and reduce expenses: The ultimate key is to save more! The more you save, the easier it will be to let go of your debts without taking out more loans. How many of us can adopt a frugal lifestyle so as to save more and spend less? Very few! If you have a cable connection but you don’t have enough time to watch television, cut off the cable. If you have subscribed to a monthly or weekly magazine but you don’t end up reading them regularly, unsubscribe them. If you love to eat out, start cooking at home and save that amount of money.
Hence, when your mortgage lender asks you about your DTI ratio, don’t fret to show it to him. Take into account all the above mentioned steps so as to maintain a low DTI ratio always and grab the best deals on your mortgage and car loan offers.