When you apply for a home loan, lenders take a look at your finances and credit history to assess the risk of lending to you. If a large portion of your monthly income goes toward paying off debt, a lender may worry that you’ll have trouble keeping up with mortgage payments.
Lenders determine whether you can afford a mortgage by calculating your debt-to-income (DTI) ratio. There are two types of DTI ratios — back-end DTI and front-end DTI. Here’s a simple breakdown of how each one works:
Housing ratio or front-end DTI
The housing ratio (also known as front-end DTI) is a percentage that shows how much of your gross monthly income goes to housing costs alone. You can calculate this by taking your proposed mortgage payment (including homeowners insurance, mortgage insurance, taxes and HOA fees), dividing it by your gross monthly income and multiplying by 100.
Back-end DTI is a percentage that shows how much of your gross monthly income goes to all monthly payment obligations. When lenders refer to “DTI,” this is usually what they mean. You can calculate back-end DTI by adding up your total debt payments for the month, dividing that total by your gross monthly income and multiplying by 100.
Here are examples of monthly payments to include in your back-end DTI calculation:
- Your proposed mortgage payment
- Your student loan payments
- Your car loan payments
- Your child support or alimony payments
- Your personal loan payments
- Your credit card payments
Note that payments for utilities, groceries or other living expenses are not included in your DTI, so you can leave them out of this equation.
What is the ideal debt-to-income ratio for a mortgage?
The debt-to-income ratio for mortgage approval can vary. Generally, lenders view a back-end DTI of less than 43% as being less risky than one that is above 43%, and paying off debt could help you get within this window. But like most things related to money and personal finance, requirements for DTI can vary and paying off debt may not be necessary for everyone.
If you have a high credit score, a large down payment and a lot of cash in the bank, a lender may accept a higher DTI. In their eyes, these compensating factors may suggest you’re still creditworthy and financially secure, even though a larger portion of your income goes to debt.