Simple mortgage definitions: Debt-to-Income (DTI)

Dan Green
The Mortgage Reports contributor
What is a debt-to-income ratio?

Debt-to-income (DTI) is a lending term that describes a person’s monthly debt load as compared to their monthly gross income. Mortgage lenders use debt-to-income to determine whether a mortgage applicant will be able to make payments on a given property. In other words, DTI measures the economic burden a mortgage would have on a household.

What’s a good debt-to-income ratio?

As a rule of thumb, a good debt-to-income ratio is 40% or less when you’re applying for a mortgage. That means your combined debts and housing costs don’t exceed 40% of your pre-tax income each month. That said, a lower debt-to-income ratio is always better. The lower your debt-to-income ratio is, the better mortgage rate you’ll get — and the more you’ll be able to afford when buying a home.

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Simple definition: debt-to-income (DTI)

Debt-to-Income (DTI) is a lending term which describes a person’s monthly debt load as compared to their monthly gross income.

Mortgage lenders use Debt-to-Income to determine whether a mortgage applicant can maintain payments a given property. DTI is used for all purchase mortgages and for most refinance transactions.

It can be used to answer the question “How Much Home Can I Afford?

Debt-to-Income does not indicate the willingness of a person to make their monthly mortgage payment. It only measures a mortgage payment’s economic burden on a household.

Most mortgage guidelines enforce a maximum Debt-to-Income limit.

Verify your mortgage eligibility (Oct 17th, 2021)

Calculating income for a mortgage approval

Mortgage lenders calculate income a little bit differently from how you may expect. There’s more than just the “take-home” pay to consider, for example. Lenders perform special math for bonus income; give credit for certain itemized tax deductions; and apply specific guidelines to part-time work.

The simplest income calculations are applied to W-2 employees who receive no bonus and make no itemized deductions.

For W-2 employees, if you’re paid twice monthly, your lender will take your last two pay stubs, add your gross income, and use this sum as your monthly household income. If you receive bonus income, your lender will look for a two-history and will average your annual bonus as a monthly figure to add to your mortgage application.

For self-employed borrowers and applicants who own more than 25% of a business, calculating income is a bit more involved.

To calculate income for a self-employed borrower, mortgage lenders will typically add the adjusted gross income as shown on the two most recent years’ federal tax returns, then add certain claimed depreciation to that bottom-line figure. Next, the sum will be divided by 24 months to find your monthly household income.

Income which is not shown on tax returns or not yet claimed cannot be used for mortgage qualification purposes.

In addition, all mortgage applicants are eligible to use regular, ongoing disbursements for purposes of padding their mortgage income. Pension disbursements and annuities may be claimed so long as they will continue for at least another 36 months, as can social security and disability payments from the federal government.

Non-taxable income may be used at 125% of its monthly value.

Verify your mortgage eligibility (Oct 17th, 2021)

Calculating debt for a mortgage approval

For mortgage applicants, calculating debt is less straightforward than calculating income. Not all debt which is listed on a credit report must be used, and some debt which is not listed on a credit report should be used.

Lenders split debts into two categories: front-end and back-end. Front-end debts are debts related to housing. Back-end debts include payments to your credit card companies, car payments, and student loans.

To calculate your debts as a lender does, sum the following figures, where applicable :

  • Your monthly minimum credit card payments
  • Your monthly car payments
  • Your monthly personal loan payments
  • Your monthly student loan payments
  • Your monthly child support and/or alimony payments
  • Any other monthly payment which is not listed on your credit report

Note that several exceptions to this list apply. For example, if you have a car loan or other payment with 10 or fewer payments remaining, the payment do not have to be included in your debt-to-income calculation. Student loan for which payments are deferred at least 12 months into the future can be omitted as well.

The sum of these figures is your monthly front-end debt.

To calculate your back-end debt, add your mortgage payment to whatever other monthly payments you make in relation to housing. This can include your real estate tax bill, your homeowner’s insurance bill, and monthly assessments to an association among other items in your PITI.

Your front-end debt and back-end debt sum to comprise your total monthly debt.

Verify your mortgage eligibility (Oct 17th, 2021)

Calculating your debt-to-income ratio

After you’ve determined your monthly income and your monthly debt load, finding your Debt-to-Income ratio is a matter of basic math. Simply divide your monthly debts into your monthly income.

Here are a few examples of the Debt-to-Income formula.

Calculating a 25% DTI

  • Monthly Social Security Income (taken at 125%): $6,000
  • Monthly recurring debts: $500
  • Monthly housing payment: $1,000

Calculating a 40% DTI

  • Monthly W-2 income: $10,000
  • Monthly recurring debts: $1,500
  • Monthly housing payment: $2,500

Calculating a 45% DTI

  • Monthly self-employment income: $10,000
  • Monthly recurring debts: $2,000
  • Monthly housing payment: $2,500

Most mortgage programs require homeowners to have a Debt-to-Income of 40% or less, but loan approvals are possible with DTIs of 45 percent or higher. In general, mortgage applicants with elevated DTI must show strength on some other aspect of their application.

This can include making a large down payment; showing an exceptionally-high credit score; or having large amounts of reserves in the bank accounts and investments.

Also, note that once a loan is approved and funded, lenders not longer track Debt-to-Income ratio. It’s a metric used strictly for loan approval purposes. However, as a homeowner, you should be mindful of your income versus your debts. When debts increase relative to income, long-term saving can be affected.

Verify your mortgage eligibility (Oct 17th, 2021)

Loans which don’t use DTI for approval

Mortgage lenders use Debt-to-Income (DTI) to determine whether homes are “affordable” for a U.S. home buyer. They verify income and debts as part of the process. However, there are several high-profile mortgage programs which ignore the DTI calculation.

Among these programs is the popular suite of “streamline” refinances available via the FHA, the VA and Fannie Mae and Freddie Mac.

The FHA streamline refinance

The FHA offers a refinance program called the FHA Streamline Refinance which specifically ignores the Debt-to-Income requirements present for an FHA purchase loan.

The official FHA mortgage guidelines for the agency’s streamline refinance program waive income verification and credit scoring as part of the mortgage approval process. Instead, the FHA looks to see that the homeowner has been making his existing mortgage payments on time and without issue.

If the homeowner can show a perfect payment history dating back 3 months, the FHA assumes that the homeowner is earning enough to “pay the bills”.  Debt-to-Income is not considered as part of the FHA Streamline Refinance.

The VA Interest Rate Reduction Refinance Loan (IRRRL)

The VA Interest Rate Reduction Refinance Loan (IRRRL) is another refinance program which waives traditional home loan Debt-to-Income requirements. Similar to the FHA Streamline Refinance, IRRRL guidelines require lenders to verify a strong mortgage payment history in lieu of collecting W-2s and pay stubs.

The “VA Streamline Refinance” is available to military borrowers who can show that there’s a benefit to the refinance either in the form of a lower monthly payment; or a change from an ARM to a fixed-rate loan.

Fannie Mae High-LTV Refinance Option (HLRO)

Customers with an existing Fannie Mae-backed mortgage might be able to refinance using the High-LTV Refinance Option (HLRO). This program is specifically designed to help homeowners with a high loan-to-value ratio refinance into a lower mortgage rate.

There’s no debt-to-income check or credit check required to qualify for Fannie Mae’s refinance option. However, if you own a single-family home, your loan-to-value ratio must be over 97%.

Fannie Mae’s HLRO is a replacement for the popular HARP (Home Affordable Replacement Program), which ended in 2018.

Get today’s mortgage rates

For today’s U.S. home buyers, Debt-to-Income (DTI) ratio plays an outsized role in the loan approval process. Buyers with a high DTI are less likely to get approved for a loan than buyers with a low DTI.

Thankfully, low mortgage rates help to hold DTI down and today’s mortgage rates remain near all-time lows. See how low your mortgage rate can be. Getting a rate quote is free and no-obligation.

Verify your mortgage eligibility (Oct 17th, 2021)