What is the Debt to Income Ratio?

Your debt to income ratio, or DTI, is exactly what it says: a ratio of your debt expenses to your income. Generally, gross monthly income (your income before taxes are taken out) is used in this calculation. The lower your debt to income ratio, the better. If your gross monthly income is $2,500, and your monthly debts payments total $250, your DTI would be 10%. Most people's DTI, however, is much higher, typically 25 to 40%. Lenders use two versions of the DTI when assessing creditworthiness:

• Front end DTI: total housing expenses per month divided by monthly gross income
• Back end DTI: total monthly housing expenses plus other debt payments (student loans, credit card payments, etc.) divided by gross monthly income

Who Uses the Debt to Income Ratio?

Debt to income ratios are first calculated and evaluated by lenders' computer programs. If the DTI is low enough, a human loan underwriter evalustes the application to make the final determination of whether a loan is approved or denied. Mortgage lenders are the primary users of DTI. However, you should know your DTI and use it to evaluate your personal financial health. If your DTI is more than 30%, you should work to lower it before applying for a mortgage. A DTI of 30% doesn't mean you won't qualify, but you could risk taking out a loan that's too big for you to comfortably afford.

What Should your Debt to Income Ratio Be?

Today, higher DTIs are considered acceptable compared to 20 years ago. Historically, a front end DTI of 28% was used as a cut-off point for mortgage lending, with a back end DTI of 36%. Today, some lenders accept front end DTIs of up to 33%, with back end DTIs of up to 41%.

Improving your Debt to Income Ratio

You have two ways of improving your DTI: increasing income and decreasing debt. Obviously, the best technique for you depends on your circumstances. If you are able to take on a second job, have a non-working spouse take a job, or get a higher paying job, you can quickly increase your DTI. If that is not possible, you should work to pay down debt by increasing the amount you pay on your credit cards and other loans each month. Setting up a budget to cut costs long term is advisable too. Do not take on more debt in the form of another credit card, personal loan, or line of credit.

Looking out for Yourself

Nobody cares more about your financial situation than you do. That's why you should take a mortgage lender's advice about how expensive a house you can afford with a pinch of salt. In many cases, banks are willing to lend you more than you should borrow. Mortgage lenders and real estate agents have a vested interest in having you buy a more expensive home, because they make more when you do. However, spending the maximum the bank will lend you on a house leaves you with little or no financial buffer should you lose your job or encounter a large, unexpected expense.

Sources:

http://www.passivelifeincome.com/financial-planning/debt-to-income-ratio-how-to-improve-it
http://www.bankrate.com/finance/mortgages/how-much-house-can-you-buy--2.aspx
http://www.realestateabc.com/loanguide/afford.htm
http://www.investopedia.com/articles/07/debt_to_income.asp#axzz1hvkOJPTL
http://www.getrichslowly.org/blog/2008/11/11/the-debt-to-income-ratio-how-much-house-can-you-afford/