How much money do you really make? And how much do you spend?
These are critical numbers to know, especially if you’re lodging a home loan application. One of the main ways lenders assess a homeowner’s borrowing power is by calculating their debt-to-income ratio, or DTI for short.
The DTI ratio compares your gross monthly income with your liabilities, such as monthly bills and debt obligations - from credit card debt or auto loans.
A DTI calculation, like your credit score, can indicate how risky you are as a borrower. A high DTI ratio could indicate you have too much debt. A low DTI ratio, on the other hand, could mean a good balance between debt and income and therefore, good financial health.
So if you want to take out a new loan or refinance, how can you use a good debt-to-income ratio to your advantage?
Let’s get into it.
How do home loan lenders calculate your DTI?
Mortgage lenders will look at a variety of expenses when it comes to calculating your DTI. To do this, they divide the amount of debt you have by your take-home pay. This gives them a value ratio or percentage they can use to assess your overall financial situation and creditworthiness.
Debts a lender may use in your DTI include:
- Credit card payments
- Buy Now Pay Later platforms
- Car loans
- Personal loans
- Student loans
- Alimony
- Child support
- Mortgage payments.
If your total debt eats up too much of your income, you will have a high debt-to-income ratio. Lenders see a high DTI as a red flag because it suggests you take on too much credit and may struggle with your loan payments.
Because many home loan interest rates change over time, the costs of your repayments may change too. If you don’t have financial wiggle room, higher interest rates may not be tenable.
A lender will also check your credit history to see if you’ve met your monthly debt payments. If there are black marks on your credit report, it could seriously hurt your mortgage application.
Australian home loan statistics 2023
What is a good debt-to-income ratio?
Different mortgage lenders will have different comfort levels regarding debt-to-income ratios. Some may be okay with higher DTIs, while others will be fairly strict.
Generally speaking, a DTI above 6 is a high DTI, while anything below 3.6 is ideal. This will apply whether you are refinancing or home buying.
How can you improve your debt-to-income ratio?
You can improve your debt-to-income ratio through two main ways: increasing your income or decreasing debt. A combination of both can be quite effective.
Increasing your income lowers your DTI because you have more cash to cover monthly bills and debts. You could take on more work hours or a side hustle or speak to your employer about a pay raise. If you plan to switch jobs, remember that home loan providers want to see at least three months of consistent income before approving your mortgage application.
Decreasing your debts also lowers your DTI because it lessens your financial drag: you have fewer bills competing against your mortgage.
Aside from paying off credit card balances or any outstanding loans, you can decrease your debt by:
- Checking your credit report for errors
- Lowering credit card limits
- Refinancing existing loans.
All of these steps can improve the chances a lender will give you the loan amount you want.
