The debt to income ratio for a mortgage is one of the most important factors lenders use when evaluating whether or not you qualify for a loan. Here’s what you should know.
What Is Debt to Income Ratio?
So what exactly is this important ratio? The debt to income ratio (DTI) plays a relatively large role in determining your creditworthiness when applying for a loan. It’s a very important metric to understand in the process of investment property financing in real estate investing.
How does it measure your ability to qualify for a mortgage? The debt to income ratio is all your monthly debt payments divided by your gross monthly income. This number is one way mortgage lenders measure your ability to manage the payments you make every month to repay the money you have borrowed. By measuring the size of your monthly debt burden, lenders can not only decide if you can take on another loan but also how much you can borrow.
Related: All You Need to Know About a Mortgage for Rental Property
How to Calculate Debt to Income Ratio for a Mortgage
In order to understand why this is such an important number, you need to learn how to calculate debt to income ratio. To calculate your debt to income ratio, you add up all your monthly debt payments and divide them by your gross monthly income. Your gross monthly income is generally the amount of money you have earned before your taxes and other deductions are taken out. When your mortgage lender calculates it, that percentage will include your potential mortgage debt burden.
Along with credit score and job stability, a low DTI is one of the main requirements to buy a house with a mortgage. The same applies for people looking to get a loan on real estate investments. Lenders calculate your debt to income ratio for a mortgage because they want to predict whether you will actually be able to pay your mortgage bills. The lower it is, the better. A low debt to income ratio means you’re managing your debt well.
Related: Can Anyone Get a Loan for Rental Property? What Does It Take?
What Is a Good Debt to Income Ratio for a Mortgage?
Like we said, generally the lower your debt to income ratio, the better. Ideally, you’d want the lowest possible DTI ratio to ensure you’re able to pay your debts while still living comfortably. A good debt to income ratio for a mortgage is 36%. This is the percentage most lenders would approve for a loan. Borrowers with low debt to income ratios have a good chance of qualifying for low mortgage rates.
A DTI higher than 43% could mean you’ll pay more interest or you may even be denied a loan. The 43% debt to income ratio rule is important to remember because anything higher can point to a risky borrower, and lenders typically stay away from anything risky. Evidence from studies of mortgage loans suggests that borrowers with a higher debt-to-income ratio are more likely to run into trouble making monthly payments. So you’d want to aim for anything below that or ideally 36%. This is especially important for real estate investors using debt to buy real estate. Since you’re most likely going to invest in multiple properties throughout your career, you’d need to manage your debt properly to ensure a low DTI.
Types of Debt to Income Ratios
There are two types of debt to income ratios for a mortgage that lenders consider.
- The Front-End Ratio: Also known as the household ratio, this type of DTI is the dollar amount of your home-related expenses- things like your future monthly mortgage, property tax, insurance and homeowners association fees. These expenses are then divided by your monthly gross income to find the front-end ratio.
- The Back-End Ratio: This type of debt to income ratio is usually higher because it takes into account all of your monthly debt obligations. In this calculation, you’d include the household expenses from the front-end ratio as well as credit cards, student loans, personal loans, and car loans.
Lenders typically focus more on the back-end debt to income ratio for a mortgage since it takes your entire debt load into account. This is the ratio that should be 36%, whereas the front-end ratio can be acceptable at 28%. Government-backed mortgages, such as an FHA loan, may be considered with higher back-end DTI’s (up to 50%).
How to Lower Your Debt to Income Ratio for a Mortgage
Making money in real estate can always be done if your expenses are taken care of and managed well. Real estate investors can decrease their debt to income ratio for a mortgage by managing their personal finances. There are different ways to lower your DTI.
One way is to avoid taking on more debt; don’t take on more than you can handle. Do this in order to make sure you can actually make your monthly mortgage payments. You should also avoid making any big purchases on credit before applying for a loan. The goal is to pay off as much of your current debt as you can before applying for a mortgage. If your DTI is too high at the moment, consider waiting before you apply. These can all lead to a lower debt to income ratio for a mortgage.
Related: How Do Investors Make Money in Real Estate If They’re Always Spending and in Debt?
Summing It All Up
Real estate investors looking to buy real estate with debt should really focus on reaching an acceptable debt to income ratio for a mortgage before applying. It’s one of the most important factors that mortgage lenders look at before approving any borrower. You can either lower your expenses or increase your gross income in efforts to have a lower DTI ratio. In real estate investing, you can increase your gross monthly income by investing in profitable rental properties. If you want to start searching for properties with high return on investment, start out your 14-day free trial with Mashvisor now.
Related: Top 10 Characteristics of a Profitable Rental Property