DTI Ratio Basics
Your debt-to-income (DTI) ratio is your total monthly obligations divided by your monthly income. It is similar to net worth expressed as a percentage, although it is admittedly not quite that simple. While net worth would count non-income producing assets, your DTI ratio only measures your total income as compared to your debt payments. DTI ratio also includes only monthly payments, rather than total outstanding debt balances as with net worth.
Let’s take a look at an example: you make $36,000 per year, which is approximately $3,000 each month. You currently have a $150 car payment, an $800 mortgage payment, and a $50 credit card payment to make every month. Your total monthly debt payments are $1,000, so your debt to income ratio would be 33 percent, or $1,000 divided by $3,000.
Why Is Your DTI Ratio Important?
Your debt-to-income ratio helps to identify your personal capacity for debt. Naturally, without more income, you would be unable to sustain a 110 percent DTI ratio. This would mean that you are paying your entire monthly income and then some to cover your debts.
In many cases, creditors look closely at your DTI ratio before lending to you to make sure that you have plenty of room to cover your debts. While it is not a perfect measurement, it is a pretty strong indicator that helps creditors to avoid giving overly risky debt loads.
Knowing you DTI, like knowing your net worth, is an important part of maintaining a strong grasp on your personal financial position. Generally, the lower your DTI ratio, the more room for error you have. Similarly, the higher your net worth, the more wiggle room there is for you.
Lender Requirements
For most mortgages, lenders require your DTI (after taking out the potential mortgage) to be under 45 percent. Any mortgage that would put you above that will very likely be denied.
Remember, lenders are taking a risk in lending to you. To mitigate their risk, they want to be sure that you have room to pay your loan even if your income drops significantly.
When shopping for a property, calculate your maximum mortgage by multiplying your monthly income by 45 percent, minus your current monthly debt payments.
Thankfully, there’s a very useful trick to loosen the strict DTI ratio barrier.
Can Lenders Cut You Some Slack on the DTI Ratio Requirement?
It depends. For multi-unit properties, almost definitely.
Thankfully, lenders will typically let you count a certain percentage of the rental income on any extra units besides the one that you will be living in. This is especially helpful for house-hackers.
For example, let’s say you make $48,000 per year. That comes out to $4,000 in pre-tax salary per month. You currently pay $200 per month in student loan payments, but you do not have any other debt. Your debt to income ratio before the mortgage is a measly 4.1 percent.
You have saved up a good chunk of cash and are looking for a property to buy. Cleverly, you want to buy a multi-unit building so you can rent out the extra units.
You find a quadruplex that you really like listed for $500,000. You have enough money saved up to make a 20 percent down payment, so you would need a $400,000 mortgage. At 4 percent interest over a 30-year term, that means your monthly payment would be $1,910. Add on projected taxes and insurance and your total monthly mortgage payment would be about $2,100.
If you were to take out a mortgage on those terms and add it to your monthly $200 student loan payments, you would have a DTI ratio of 57.5 percent, much too high to meet the 45 percent requirement. Looks like you’re out of luck?
BUT WAIT: your lender allows you to calculate the projected income for the other three units into your monthly income for DTI ratio purposes.
Your lender projects that the other three units would rent for $950 each. They are allowing you to add 80 percent of the rental value of those three units, meaning you can add an additional $2,280 onto your projected monthly income.
When you put your actual income together with your lender’s projection, you now have $6,280 in monthly income on paper. Now, when you divide your $2,300 in projected monthly debt against your projected income of $6,280, your DTI ratio drops down to a healthy 37 percent.
Buying Income Properties Allows You to Decrease Your DTI Ratio
The mortgage that might otherwise be out of reach is now within reach since it’s being used on an income-producing multi-unit building. Do not be afraid to use this to your advantage if you find a property that works as a rental!
By decreasing your estimated DTI ratio, you will be able to buy larger, income-producing properties more quickly to start building wealth in real estate.
Conclusion
Your DTI ratio is a very important measurement for analyzing the risk in lending to you. The lower your DTI ratio, the more favorable you will appear to prospective lenders.
Buying multi-unit buildings that you intend to live in can let you decrease your estimated income to lower your DTI ratio since lenders can add the projected rent from the other units to it. This can allow you to acquire larger properties with higher income-producing potential!
Always know where you stand, and always look for ways to optimize your position. It will help you go farther in your investing career, rather than get stuck in underwriting.