The “debt-to-income ratio“, or “DTI ratio” as it’s known in the industry, is the way a bank or lender determines what you can afford in the way of a mortgage payment.
By dividing all of your monthly liabilities (including the proposed housing payment) by your gross monthly income, they come up with a percentage. This key figure is known as your DTI, and must fall under a certain number in order to qualify for a mortgage.
Update: Thanks to the new Qualified Mortgage rule, most mortgages have a maximum back-end DTI ratio of 43%. However, there is a temporary exemption for many loans, but a lot of lenders still want this number to be under 43%!
Let’s look at a basic example of debt-to-income ratio:
$120,000 annual gross income as reported on your tax returns/pay stubs
- Monthly liabilities: $3,500
- Monthly gross income: $10,000
- 35% debt-to-income ratio
In this example, your debt-to-income ratio would be 35% ($3,500/$10,000). Pretty simple, right?
Well, the debt-to-income ratio goes into greater detail and comes up with two separate percentages, one for all of your monthly liabilities divided by income (back-end DTI ratio), and one for just your proposed monthly housing payment (including taxes and insurance) divided by income (front-end DTI ratio).
Front-End and Back-End Debt-to-Income Ratios
So in the above example, if your proposed monthly housing payment makes up $2,000 of your $3,500 in monthly liabilities, your front-end DTI ratio would be 20%, and your back-end DTI ratio would be 35%. Many banks and lenders require both numbers to fall under a certain percentage, though the back-end DTI ratio is more important.
You may see a debt-to-income requirement of say 30/45. Using the example from above, your front-end DTI ratio of 20% would be 10% below the 30% limit, and your back-end DTI ratio of 35% would also have 10% clearance, allowing you to qualify for the loan program, at least as far as income is concerned.
*If you own other property with a mortgage, it should be included in the back-end DTI ratio because it’s not part of the new loan you are applying for.
Max DTI for Conforming Loans (Fannie Mae and Freddie Mac)
The classic, “rule of thumb” ratios are 28/36, meaning your front-end ratio shouldn’t exceed 28%, and your back-end ratio shouldn’t exceed 36%.
However, this measure is more conservative than what you might actually see in practice today. For example, back in the day many homeowners put down 20%. Today, the down payments are often just 3-10%, to give you some perspective.
But, Fannie Mae still does impose a max DTI of 36% for manually underwritten loans, though the majority of loans are approved via their automated underwriting system called Desktop Underwriter (DU).
And DU will allow DTIs up to 45%, and as high as 50% with compensating factors, such as plentiful assets, larger down payment, great credit, etc.
For Freddie Mac, underwriters must include a written explanation that justifies exceeding the 28/36 ratios when files are manually underwritten. Like Fannie, the ratios may go higher if the file is approved via automated underwriting.
Max DTI Ratio for FHA Loans
The max DTI for FHA loans depends on both the lender and if it’s automatically or manually underwritten. Some lenders will allow whatever the AUS (Automated Underwriting System) allows, though some lenders have overlays that limit the DTI to a certain number, say 55%. These limits can also be reduced if your credit score is below a certain threshold.
For manually underwritten loans, the max debt ratios are 31/43. However, for borrowers who qualify under the FHA’s Energy Efficient Homes (EEH), “stretch ratios” of 33/45 are used.
These limits can be even higher if the borrower has compensating factors, such as a large down payment, accumulated savings, solid credit history, potential for increased earnings, and so on.
To sum it up, if you can prove to the lender that you’re a stronger borrower than your high DTI ratio lets on, you might be able to get away with it. Just note that this risk appetite will vary by lender.
Also note that mortgage insurance premiums are included in these figures.
Max DTI Ratio for VA Loans
For VA loans, the same automated/manual UW rules apply. If you get an AUS approval, the maximum DTI ratio can be quite high.
However, if it’s manually underwritten then the maximum debt-to-income ratio is 41% (back-end). There is no front-end requirement for VA loans. Again, as with FHA loans, if you have compensating factors and the lender allows it, you can exceed the 41% threshold.
Specifically, if your residual income is 120% of the acceptable limit for your geography, the 41% DTI limit can be exceeded, so long as the lender gives you the go-ahead.
In other words, most of these limits aren’t set in stone, assuming you’re a sound borrower otherwise.
Max DTI Ratio for USDA Loans
For USDA loans, the max DTI ratios are set at 29/41. However, if the loan is approved via the Guaranteed Underwriting System (GUS), these ratios can be exceeded somewhat, similar to FHA/VA loans.
Long story short, if you have a credit score of 660 or higher, solid employment history, and the potential for increased earnings in the future, you may get approved for a USDA loan with higher qualifying ratios.
How to Calculate Your DTI Ratio
If you’d like to figure out your debt-to-income ratio, simply take your average gross annual income based on your last two tax returns and divide it by 12.
So if you made on average $100,000 gross (before taxes) each year for the past two years, that would equate to $8,333 per month in income.
Then add up all your monthly liabilities and your proposed housing payment (including taxes, insurance, HOA if applicable) and divide that total by your monthly income and voila.
When I say liabilities, I mean all the minimum payments that appear on your credit report. Bills that don’t show up on your credit report generally aren’t counted toward your debt-to-income ratio because they aren’t credit-related and/or documented.
For example, health insurance premiums, a cell phone bill, cable bill, gardening bill, or a pool service may not figure into your DTI. This is a good thing if you’re cutting it close.
Keep in mind that you’ll need a free credit report to accurately see what all your monthly payments are.
A credit report will show you what your minimum or monthly payment is for each tradeline, which makes it simple to add them up. Some banks and lenders allow installment credit cards such as those issued by American Express to be excluded from the debt-to-income ratio as they often account for thousands of dollars a month, and likely get paid off in full monthly.
Let’s assume you’ve got $1,000 in monthly liabilities on your credit report thanks to some credit cards and a car loan, and a proposed housing payment of $2,000. If we combine those two figures, we come up with $3,000.
Now simply take that $3,000 figure and divide it by our original income figure of $8,333. That gives us a debt to income ratio of 36%. This number is below the maximum and should be sufficient to get a mortgage, as long as you qualify otherwise.
By the way, the front-end ratio would be 24%, which is $2,000 divided by $8,333.
The debt-to-income ratio is a great way to find out how much house you can afford, as well as the maximum mortgage payment you qualify for. Simply add up all your liabilities and your proposed mortgage payment plus taxes and insurance to see what type of loan you can take out.
What Is a Good Debt-to-Income Ratio?
Unlike a credit score, where higher is better, a good debt-to-income ratio for a mortgage is one that is low.
But like credit scores, which stop benefiting you at a certain level, there’s a point where it doesn’t matter how low your DTI is either.
Really, you just want/need it to be below the key thresholds listed above. As long as you’re below those numbers, you’re “good.”
So just focus on being below the maximum ratios and you’ll have a good shot at getting approved for a mortgage, assuming you meet the other qualifying criteria for things like credit history, assets, and so forth.
Tip: If your DTI is too high, you might be able to lower it by putting more money down and/or buying down your interest rate, both of which will reduce the monthly payment.
Stated Income to Avoid Debt-to-Income Ratio Problems
Most mortgage brokers that work with potential homeowners will avoid full documentation loans if they feel the borrower won’t qualify for the loan based on their gross income alone. For this reason, banks and lenders offer reduced documentation loans such as SIVA (Stated income, verified assets) loans, and No Ratio (no income, verified assets) loans.
Many people think reduced-doc loans are usually just stretching the truth, but they can also come in handy for borrowers who have increased their gross income recently, or those with complicated tax schedules, usually self-employed borrowers.
Qualifying Rate for Debt-to-Income Ratio
One important thing to keep in mind is the qualifying rate banks and lenders use to come up with your debt-to-income ratio. Many borrowers may think that their start rate or minimum payment is their qualifying rate, but most banks and lenders will always qualify the borrower at a higher rate to ensure the borrower can handle a larger amount of debt.
For a bank or lender to effectively gauge the borrower’s ability to handle debt, especially once the minimum payment is no longer available for the borrower, the lender must qualify the borrower at the higher of the two payments. This gives the lender security and prevents under-qualified borrowers from getting their hands on mortgages they can’t really afford.
Borrowers should also note that most debt cannot be paid off to qualify. If you have debt on credit cards or other revolving accounts and plan to pay them off with your new loan, their monthly payments will still be factored into your DTI. This prevents a borrower from refinancing their current mortgage or buying a new home and piling all their outstanding debt on top of the mortgage, just to rack up more debt on those cards a month later.
It also allows the bank or lender to gain a true measure of a borrower’s ability to handle debt. However, lenders will usually allow borrowers to pay off installment debt to qualify so long as they have sufficient, verified assets.
Download my Excel Debt-to-Income Ratio calculator below to figure out what you can afford: Debt-to-Income Ratio Calculator
Read more: Do I qualify for a mortgage?