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Your debt-to-income ratio is a simple calculation of adding up your monthly debt and dividing it by your gross income. But why is your debt-to-income ratio – also called DTI – so important?
Here are three reasons.
Debt-to-Income Ratios Indicate Financial Stability
The first thing to reference is how your DTI helps show how strong your finances are right now.
For example, let's say your monthly debts are $3,000 and you make $5,000 in gross income. That means your DTI is $3,000/$5,000 = 60%. That's high, meaning you don't have a lot of "wiggle room" in your finances to deal with an unexpected event.
To help illustrate why let's see how that breaks down.
If you make $5,000 a month in gross income, that means after taxes you'll probably be left with around $3,350. If $3,000 is going towards your debts, you only have $350 leftover to live on. That's your food, gas, entertainment, insurance, etc. It won't go very far.
Compare that to someone else who also makes $5,000 a month but their debts are only $1,400. That person would have about $1,950 to live on every month, which is a lot more doable.
Debt-to-Income Ratios are Important to Qualify for a Mortgage
Because of the first point we made – DTI helps indicate financial stability – lenders use this ratio to help them determine if you'll be able to qualify for a mortgage at all.
Every lender and loan is different, but we can look at common benchmarks to give you an idea of what to shoot for. Here are three numbers to keep in mind.
- 43% is generally considered the highest debt-to-income ratio a lender is willing to work with. If your DTI is higher than that, you may need to lower it to qualify for a mortgage.
- 36% is seen as the benchmark to get the best rates. This includes all of your debts including credit cards, student loans, car loans, etc.
- 28% is the ideal for your mortgage alone. So in the case above where your income is $5,000 a month, a lender would prefer your mortgage payment isn't over 28% of $5,000, which comes out to $1,400.
Now let's talk about the third reason why DTI is important.
A Good Debt-to-Income Ratio Saves You Money
Let's compare two scenarios.
Bob has a DTI of 43%, so he can get a mortgage but it won't be the most competitive. His rate comes out to 4.5% on a $250,000 mortgage over 30 years.
Susan has a DTI of 25%, so she'll get a great rate on her mortgage. It came out to 3.5% on the same $250,000 loan over 30 years.
Bob's monthly payment would be about $1,267. Susan's is $1,123, so she's paying $144 less than Bob every month.
Not a big deal, right? But $144 x 12 months/year x 30 years = $51,840! Bob's paying a lot more over time simply because his DTI was higher, and he got a less competitive mortgage rate.
Do you have any questions about debt-to-income ratios? Give us a call at (877) 306-0222 and we'll see what we can do to help.