Most homebuyers understand that their debt could be affecting their credit. Addressing and reducing debt is one of the first steps experts recommend when people start getting ready to purchase a new home.
Keeping your debt under control an important key to maintaining a good financial healthy but how do you tell if you’re leaning into too much debt? Thankfully you don’t have to wait until you’re trying to qualify for a mortgage to determine whether you have too much debt. There’s a simple calculation you can use to estimate your debt load: debt-to-income ratio.
What’s Debt-to-Income Ratio?
The debt-to-income (DTI) ratio is a calculation of your monthly debt payments divided by your gross monthly income. You can calculate your DTI by adding up all of your monthly debt payments and dividing them by your gross monthly income (the amount you earn before taxes and deductions are taken out).
Why is DTI important?
Your DTI is important because lenders use it to determine your ability to repay a loan. A low DTI shows lenders that you have a good balance between your debts and income. Similarly, a high DTI means you’re carrying too much debt.
Lenders calculate DTI in two ways:
- The first way is to add your expected housing expenses (your new mortgage, including taxes and insurance) and divide that by your gross monthly income. This number is your front-end DTI.
- The second way is to do the same calculation but include your total monthly expenses (monthly credit card payments, car or student loan payments, and any other debts). This number is your back-end DTI.
How do I improve my DTI?
If your DTI is close to, or higher than, 36%, you may want to take steps to reduce it. Here are some ways you can accomplish that:
- Reduce your debt. Make a concentrated effort to pay down or off your outstanding debts. Extra payments will help you knock out your debt more quickly.
- Increase your gross monthly income. Another option is to increase your gross monthly income. This option isn’t always a viable as it will need to be a consistent source of additional income.
- Avoid taking on additional debt. Reduce the amount you charge on your credit cards and avoid opening new lines of credit. You may also want to postpone any large purchases that you’ll have purchase with credit as well. Instead, try saving for the purchases so you can reduce the amount you need to finance.
If you’re in the market for a mortgage, be sure to keep an eye on your DTI. Many people assume that a good credit score and income are enough to secure a mortgage. Keeping your DTI low will help make sure you’re better qualified to secure credit for the things you truly want.