Definition of Debt to Income Ratio
The debt-to-income ratio measures a person’s debt against their disposable income. It’s a simple calculation used by mortgage lenders to determine how much of your monthly income goes towards paying off your monthly debt. The debt-to-income (DTI) ratio is expressed as a percentage and calculated by dividing your minimum allowed monthly debt payments by your gross monthly income.
Why is this term important?
The DTI ratio is a simple calculation used to determine how much of your monthly income goes towards paying off your monthly debt. By calculating this ratio, lenders get an idea as to whether or not you can manage your current debt and how much additional debt you can take on.
When your debt-to-income ratio is low, you can easily pay your bills, save for your future and take on more debt, such as a mortgage on a house. When your DTI ratio is too high, you may be spending more money than you earn and could be left with very little money for spending or saving. A high DTI ratio will also impact your chances of qualifying for a mortgage.
If your DTI ratio is below 20%—so one-fifth of your gross income is used to pay the minimum on your current debt—you will probably find it easy to get a mortgage at the best-discounted rates currently available (depending on income verification and other factors). A DTI ratio that hovers around 43% is the highest ratio a borrower can have and still qualify for a standard mortgage.
Keep in mind there are exceptions. For instance, those that are self-employed or who work on contract may require a lower DTI ratio to qualify for a mortgage, while large mortgage lenders may still offer a mortgage loan to someone with a DTI ratio that’s greater than 43%, if other factors are considered and the lender can reasonably determine that the person has ways and means to repay the loan.
For anyone thinking of getting into the housing market, a mortgage lender will first verify that your DTI ratio is acceptable. Then they’ll verify whether or not you have a good credit score. That’s because to a lender, housing affordability translates into whether or not you can be expected to make the debt repayments.
Initially, lenders will use the debt-to-income ratio to determine if you’re able to take on a mortgage debt. If you meet the requirements of this basic ratio, your lender will then use one of two additional debt ratios to qualify you for a mortgage. The first is the Gross Debt Service ratio (known as the GDS) and the second is the Total Debt Service ratio (known as the TDS).
GDS and TDS are two mortgage formulas that lenders use to determine exactly how much money they are willing to lend you. As of 2017, the GDS or TDS can be as high as 39% to 44%, respectively and your credit score must be at least 680.
Examples of term
If you pay $1,200 in rent each month, make a car loan payment of $300 a month and pay $500 a month towards your student loan debt, your monthly debt payments total $2,000. If your gross monthly income is $4,000, then your debt-to-income ratio is 50% and it’s unlikely that you will qualify for a mortgage.