Along with your credit score, your debt-to-income ratio (DTI) is a crucial data point used by lenders to determine whether a consumer will be approved for certain types of loans. Your DTI compares your gross monthly income with your monthly debt payments and is designed to help lenders determine if you'll be able to take on another loan payment.
Depending on the institution and type of loan, lenders each have a range of DTIs that they accept. Knowing your DTI and what it means to lenders can be the first step to understanding what types of loans you can apply for and which ones you might get approval.
What Is an Ideal Debt-to-Income Ratio?
There is no one DTI that all lenders require. Rather, your DTI is just one of the components of your financial profile that lenders will look at when considering you for a loan. That said, certain lenders do prefer that their borrowers' DTIs remain below certain levels.
Your DTI will be most important when it comes to getting approved for a mortgage, one of the biggest loans you might take out in your lifetime. Since there are many different types of mortgages, knowing your DTI will help you narrow down which loan might be best for you. Here are some examples:
A conventional home loan or mortgage is a type of loan that is not backed by the government and is given to the borrower directly from a bank, credit union, or mortgage lender. According to Fannie Mae, one of the largest purchasers of conventional loans, in order for them to buy a conventional loan the borrower's DTI has to be 36% or lower. For borrowers with credit scores and assets over a certain threshold, the maximum DTI can sometimes be as high as 45%.
An unconventional home loan or mortgage is a loan that is secured by a government agency such as the Federal Housing Association (FHA) or the Veterans Administration (VA). When considering borrowers for new mortgages, the FHA takes into consideration two types of DTI calculations: front-end DTI and back-end DTI.
When using your front-end DTI—which is calculated by dividing the total of only the monthly debt paid toward housing costs by your gross monthly income—the FHA limits the borrower's ratio to 31% or under. When they use your back-end DTI—which is calculated by dividing the total of allyour monthly debt payments by your gross monthly income—the FHA sets the maximum DTI to 43%.
A few factors can increase the FHA's DTI requirements, such as having a credit score above 580 or other factors like verified cash reserves and additional income. In cases like this, borrowers looking to get an FHA-backed loan can have DTIs up to 50%.
When it comes to other types of loans, like a personal loan, the limit for DTIs may be higher than for mortgages, as the size of the loan will in many cases be smaller. Still, the lower your DTI and the higher your credit score, the better positioned you are to get the specific loan that you might want.
How Can I Improve My Debt-to-Income Ratio?
While there are many credit options available for people with different DTIs, you may still want to lower your ratio so that you can know more about where you stand when applying for different loans.
There are really only two things you can do to help improve your debt-to-income ratio:
- Increase your monthly income
- Decrease your monthly debt burden
Once you do either of these two things, plug your new monthly debt payment or gross income back into your DTI calculation and you will find that your percentage has decreased.