Your debt-to-income (DTI) ratio is one of many things that lenders will consider when you’re applying for your home equity loan. It is a personal finance measure that takes all your monthly debt payments and divides them by your gross monthly income (the amount of money you have earned before your taxes and other deductions are taken out). This calculation represents a key indicator of a person’s overall financial health. It is used to compare what you earned to the total debt amount you’ll have after being approved. More specifically, your debt-to-income ratio will help a lender to estimate the amount that you’ll be able to pay on loan after making your existing payments. Applicants that have kept their debt to a minimum relative to the earnings will more likely get the loan they applied for, along with many other favorable terms. In case you’re not one of them, some lenders, like Skydan Equity Partners, can help you reduce your DTI ratio by using a part of your home equity loan to pay off the existing debts.
Which factors make up a DTI ratio?
There are two components that are mortgage lenders using for a debt to income ratio, and here is a closer look at how both of them are calculated:
- Front-end ratio – This one is also known as the housing ratio. It shows the percentage of your monthly gross income that goes toward your housing expenses, including your property taxes, mortgage monthly payment, homeowners association, and homeowners’ insurance.
- Back-end ratio – This ratio shows the portion of your income needed to cover all of the monthly debt obligations that you have, as well as your housing expenses and mortgage payments. Including your credit card bills, child support, student loans, car loans, or any other revolving debt on your credit report.
What is your Debt-to-Income ratio, and what does it tell you?
As you start to shop for a home equity loan, it’s essential to know your DTI ratio. Here’s how you can do that – add up the total post-approval debt and make sure to include your:
- Credit card debt
- Home payments
- Car loans
- Student loans
- The estimated monthly payment on your potential home equity loan
Divide your total sum into monthly pretax income, and you will get your DTI ratio. The result will yield a decimal, so you’ll have to multiply it by 100 to achieve your debt-to-income ratio percentage.
A low DTI ratio represents the right balance between your income and debt. If your DTI ratio is, for example, 15%, that means that 15% of your monthly gross income will go to the debt payment every month.
Conversely, a higher ratio usually signals that a person has too much debt for the income that is earned each month.
Borrowers that have low DTI ratios are generally managing their monthly debt payments more efficiently. As a result of that, financial credit providers and banks want to see lower debt-to-income rates before issuing a loan to the potential borrower. This preference for lower ratios makes sense because lenders need to make sure that the borrower is not overextended, which means that he has too many debt payments relative to the income.
Assessing the numbers
As evidence from studies of mortgage loans suggests, borrowers with a higher debt-to-income ratio are more likely to run into problems trying to make their monthly payments. As a general guideline, the highest DTI ratio that a borrower is allowed to have to get still qualified for a mortgage is 43 percent. They set this minimum to be sure that you won’t accidentally overextend yourself, as you pursue your lifestyle and financial goals. The ideal DTI ratio that lenders prefer is 36 percent, with no more than 28% of that debt going toward servicing a rent payment or a mortgage.
In case your ratio exceeds this 43 %, you should consider reducing it before applying for a home equity loan. You can start by paying down your existing debt like credit cards in order to reduce your total debt and drive down your debt to income. After that, you will be able to take advantage of all the benefits that a home equity loan offers to you while maintaining healthy financial habits.
However, there are some exceptions to this 43% rule. For instance, if you are lending money from a small creditor, they must consider your debt-to-income ratio but are allowed to offer you a Qualified Mortgage with a debt-to-income ratio higher than 43%. A lender is considered to be a small creditor if they had under 2 billion dollars in assets in the last year and they made no more than 500 mortgages in the previous year. Also, large landers may still land you the money for your mortgage if your DTI ratio exceeds 43%, even if this prevents it from being a Qualified Mortgage. This means that they will have to make an extra effort following the CFPB rules to determine if you have the ability to repay the loan.
The maximum debt-to-income ratio varies from lender to lender. Anyway, the lower the ratio, the better the chances you have to be approved, or at least considered for the credit application.
Debt-to-income ratio and credit score
Your DTI ratio doesn’t directly affect your credit score because credit agencies don’t have the information on how much money you earn to be able to make the calculation. They do, however, look at your credit utilization ratio or debt-to-credit ratio. This ratio compares all your credit card account balances to the total amount of credit (the sum of all the credit limits on your cards) you have available. The more you owe relative to your credit limit, the lower your credit score will be. You can fix a poor debt-to-credit ratio by creating a budget, paying off your debts, and making a smart saving plan.
How to lower the DTI ratio?
There are two ways to lower the DTI ratio:
- Reduce your monthly recurring debt
- Increase your gross monthly income
You can also use the combination of the two. Reducing debt is easier said than done. Your best chance is to make an effort to avoid going further into debt by considering needs versus wants. Needs are those things that are necessary to survive, such as food, shelter, clothing, healthcare, and transportation. Wants are things you wish to have but are not necessary for your survival. Once your needs have been met each month, you might have a portion of income to spend on wants. It makes financial sense not to spend too much money on the things you don’t need. You could also create a budget that includes paying the debt you already have. You could also try to increase your income by:
- Finding a second job or work as a freelancer in spare time.
- Work more hours or overtime at your main job.
- Ask for a pay increase.
- Completing coursework or licensing that will increase your skills, and obtain a new job with a higher salary.