When you’re in need of financial solutions, like home equity loans, HELOCs, or bridge loans, there are several factors that lenders take into consideration when deciding whether or not to qualify you and for how much. Having a strong understanding of your debt-to-income ratio (DTI) is the first step to helping you qualify for a loan.
Besides your credit score, DTI is one of the most important factors to determine your potential loan. But what exactly is DTI and how it is counted? DTI can be confusing since certain expenses are considered while others are not. So let’s break down DTI in more detail.
What Is DTI?
Your debt-to-income ratio is a way lenders measure your ability to manage monthly payments to repay the money you plan to borrow. It’s important to have an understanding of the two different types of debt-to-income ratios:
- Front End Ratio
- Back End Ratio
Front End covers your total housing expenses and obligations. Back End Ratio covers your total housing expenses, plus all your monthly debt obligations.
Most lenders focus on the Back End Ratio. This is calculated by taking all your monthly debt payments and dividing that by your gross monthly income. Your gross monthly income is the amount of money you have earned for the month before taxes and deductions. If you pay $1,600 a month for your mortgage, $100 for your car loan, and then another $300 in remaining debts, then your monthly debt payments come to $2,000. If your gross monthly income is $5,000, then your debt-to-income ratio is 40%.
Understanding What Goes Into Debt-To-Income Ratio
When it comes to understanding your debt-to-income, it can be tricky to distinguish what payments do and don’t count toward it. Typically, when calculating your DTI, you should take into account the following types of debt:
- Monthly mortgage payment
- Minimum credit card payments
- Auto, student, or personal loan payments
- Monthly alimony or child support payments
- Any other debt payments that show on your credit report
Understanding What a Good Debt-To-Income Ratio Means
If you’re looking to access a loan, understanding what a good debt-to-income would be for lenders is important. Most lenders will be looking to see a Front End Ratio of no more than 28%. Back End Ratio of less than 43% to approve you, though some will go as high as 50% depending on your credit score, savings, assets, down payment, and the type of loan you’re looking for.
How Can I Lower My DTI?
There are a few actions you can take if you are looking for an understanding of how to lower your debt-to-income ratio to qualify for a loan, such as:
- Create a budget/Track spending: When you reduce unnecessary purchases, you’ll be able to put more money toward paying down debt.
- Plan a way to pay off debt: There are two common ways to pay off debt. The snowball method is the first, which means you pay down small balances first while making payments on the other. Once the smallest has been paid off, you move to the next smallest in size and so on. The second is the avalanche method, which involves paying off the higher interest debts first. By choosing a plan and sticking to it, you’ll be able to lower your debts.
- Make your debt less expensive: Look into ways to lower the rates on your high-interest credit cards. This is typically easiest for those who have accounts in good standing and who pay their bills on time. Another option is to take out a personal loan, consolidating your debts into a loan with a low-interest rate and one monthly payment.
- Avoid new debts: Don’t make large purchases on your credit card or take on any new loans for large purchases. New loans can raise your DTI and lower your credit score. Avoid too many credit inquiries as well, as those can negatively affect your score.
If you’re looking to create a plan to improve your finances, check out our financial planning tips.
The Alternative Solution
A strong understanding that a strict debt-to-income can deter many homeowners from qualifying for loans or reaching their financial goals. Instead of dealing with life-changing and high-stress solutions, there is another path homeowners can take. A sale-leaseback program offers solutions that allow homeowners to convert their equity into cash. How to get a loan with high debt-to-income ratio? You simply sell your house but stay there as a renter. When you’re ready, you can repurchase your home or move to a new one. You’ll get the cash you need without the struggle of dealing with lenders or the stress of moving out when you’re not ready.
Understanding debt-to-income ratio is an important part of getting a loan. If yours is less than ideal, you can look for other alternatives. Talk to a financial advisor to figure out which solution might be the best for you.