If you’re thinking of buying a home, the amount of monthly income and monthly debt are important factors for you to consider. This relationship between debt and income is called a debt-to-income ratio or DTI. It’s a measure that compares how much debt you have to your overall income. Mortgage lenders – like FirstBank Mortgage – will look at this measure to help determine what size loan you are eligible for. A healthy DTI can indicate that you’ll be able to repay the money you’ve borrowed.
It’s calculated by dividing your total recurring monthly debt (like rent or house payment, car payment, student loans, child support, credit card payments, insurance, etc.) by your gross income. Gross income is how much money you make before taxes. Here’s an example of the calculation:
Total monthly obligations: $1,200 for your mortgage + $400 for your car + $500 for the rest of your debts = $2,100
Gross monthly income: $6,500
To calculate DTI, take your total monthly debt ($2,100) and divide by your gross monthly income ($6,500). This equals your DTI.
$2,100 / $6,500 = .32 or 32%
In general, mortgage lenders prefer a debt-to-income ratio smaller than 43 percent, although there are some programs that are more flexible, like FHA and VA loans. If you have a low debt-to-income ratio, that demonstrates a good balance between your debts and income. As a general rule, the lower this percentage, the more likely you are to be approved for the type of loan and loan amount requested.
But what if your DTI is too high? What can you do?
If you’ve done the calculation and your DTI is higher than 43 percent, there are ways you can change it. Read on for 5 simple tips for lowering your debt (and your DTI)!
FIVE TIPS FOR LOWERING YOUR DEBT-TO-INCOME RATIO
1. Create a Budget
Reducing debt is no easy task. To help avoid going into further debt, think about your monthly needs versus wants. Needs include shelter, food, clothes, transportation and healthcare. Wants are just that – things you want but don’t need to survive. Limiting the amount of money you allow for “wants” every month will give you more cash to put directly towards your debt.
2. Develop a Debt Repayment Strategy
Writing down (and committing) to a higher monthly debt repayment is the first step. Extra payments each month can quickly help you lower your overall debt.
3. Put Off Large Purchases
… unless you have cash. The less you put on any credit card, the better.
4. Increase Your Monthly Income
Any increase to what you bring home can be applied to your debt and will impact your DTI. Some other sources of additional income include finding a second job, working as a freelancer in your spare time, or working overtime hours at your current job.
Another option is to ask for a new position at work or training to help you move to the next level in your career. Any additional salary that results can be applied directly to your debt while increasing the amount you bring home each month.
5. Recalculate Your DTI Monthly
Reducing debt isn’t always easy or much fun. When you recalculate your debt-to-income ratio each month, you can see the positive effects of your hard work. Seeing the results and keeping the endgame in mind (like owning your own home) can help you stay laser-focused on your goal.