How To Calculate Your Debt To Income Ratio (DTI) (And Why It’s Important)

How To Calculate Your Debt To Income Ratio (DTI) (And Why It’s Important)

Lenders use a lot of data to determine how much mortgage a borrower can afford. A lot of the information – notably, most of the debts you owe – is contained on your credit report.

To determine your income, lenders will perform an income and employment verification by contacting your employer and also by looking at your tax returns. Once they know both – your income and your debt obligations – they compare what you owe to what you earn to determine what’s called your “debt to income ratio”- or DTI, an important tool in helping lenders determine how much mortgage you can afford (based on their own requirements and safety margins).

There are two types of DTIs, known as front-end and back-end DTIs (some lenders may refer to them as the housing expense and total DTI ratios, respectively). Learn how to calculate your debt to income ratio and you’ll be ahead of the power curve.

Housing Expense Ratio (Aka Front-End DTI)

This ratio looks specifically at potential mortgage costs, regardless of other debts you may owe. Essentially, the front-end ratio looks at how much of your gross monthly income would be used up in paying your mortgage payment, which is defined as the principal and interest on the loan in addition to real estate taxes and homeowners insurance.

Although different lenders may have different acceptable safety margins, the industry standard assumes that your mortgage payment should not exceed 28% of your gross monthly income. You can get a ballpark idea of your front-end DTI by multiplying your gross monthly income by 28%, or if you have your tax returns handy (and if you’re shopping for a mortgage, you should), multiplying your annual income by 28% and then dividing by 12. The answer is the maximum front-end ratio – that is, the upper monthly mortgage payment limit for most lenders.

Example: Your annual income is $100,000.

($100,000 x .28)/12 =$2,333 is your front-end ratio

(Before you get too excited, remember – that’s your principal, interest, taxes and insurance, all rolled into one)

Total Debt Ratio (Aka Back-End DTI)

Unlike the front-end ratio, the back-end ratio looks at how much of your monthly gross income is dedicated to total debt payments, including credit cards, alimony and support, car loans, student loans and any other debt obligations in addition to your mortgage (principal + interest + real estate taxes+ homeowners insurance). Like the front-end ratio, there’s a magic number above which most lenders fear to tread; in this case, it’s 36%, which means that all your debts should not exceed 36% of your total monthly income. So:

Example: Your annual income is $100,000.

($100,000 x .36)/12 =$3,000 is your back-end ratio

That means all your monthly debt payments combined should not be more than $3,000.

As noted, different lenders have different safety margins, so your calculations will likely differ from lenders’ figures. Having a rough idea of your DTI is really useful in figuring out how much house you can really afford, so you might want to take some time to calculate it before you go house shopping.