Understanding debt can be tricky, but it’s important to learn how it works and what lenders consider when determining mortgage eligibility. Keep in mind, while you may want to pay down debt before you apply for a home loan, you might not need to pay it all off. Here are a few things that are important to understand about debt.
What is debt-to-income ratio?
Basically, debt-to-income ratio (DTI)? is how much debt you have compared to your income. As credit scores? help lenders determine how likely a borrower is to make payments on time, DTI helps them determine whether you’ll have trouble making monthly mortgage payments. Lenders view this as a key indicator of how well you manage money and whether you can afford to take on more debt.
How DTI impacts qualifying for a home loan
As long as the DTI ratio is under 50 percent, you may qualify for a mortgage loan. If it’s above 50 percent, you’ll want to take steps to lower it before applying for a mortgage. Your DTI ratio will be a strong factor when determining how much you’ll be approved to borrow, your interest rate?, and other loan terms. So even if it’s near 50 percent, you may want to lower it before applying for a mortgage.
You can figure out your DTI ratio by adding up your total monthly debt payments and then dividing that amount by your gross monthly income, which is the total monthly income before taxes are deducted. Your monthly debt payments may include your rent, any student loans or car loans, alimony and child support, minimum credit card payments, and any other debt. When you apply for a loan, the new monthly loan payment will become a factor when determining your total DTI vs. what you currently pay for housing/rent.
For instance, let’s say that every month your total monthly debt payments are $900. Then, if you make $28,000 a year, your gross monthly income is $2,333. To calculate DTI, divide $900 by $2,333, which comes out to 0.39. Then multiply this by 100 to get your current DTI ratio of 39%.
Ways to improve your DTI
If your DTI ratio is high, you can improve it by trying a few techniques. First, review your budget to find some extra money to put toward paying off your debt. You can also review your current credit report? for an overview of all your debts and the payments associated with them. Avoid large purchases, especially if it adds to your debt. This can be hard, but the purchases you make while trying to qualify for a home loan may impact your approval status. Last, give yourself time to pay it down. It won’t happen overnight.