Finding a home you can afford is hard enough these days. But even that’s only half the battle: If you’re like most buyers, you still have to qualify for a mortgage, too.
And before a lender hands you a check for hundreds of thousands of dollars, they’ll want you to meet some pretty exacting standards. In fact, even if you have a good credit score and earn a steady income, there’s one big factor that can hurt your chances at getting a mortgage or a loan, regardless of how responsible you are.
We’re talking about your debt-to-income ratio, and it matters a lot more than you probably think.
What Is Debt-to-Income Ratio?
The concept behind your debt-to-income ratio isn’t that hard to understand. Basically, it’s the amount of debt you have compared to your income.
If you want to get fancy, the Consumer Financial Protection Bureau (CFPB) explains debt-to-income ratio as “all your monthly debt payments divided by your gross monthly income.” To calculate your debt-to-income ratio, just add up all your monthly debt obligations — including car payments, student loans, credit card minimum bills, and your potential mortgage — and divide them by your gross monthly earnings.
Here’s how it might work: Let’s say you have approximately $3,000 in debt payments each month, including housing, and earn $60,000 a year before taxes (that’s your “gross” income). Divide that salary by 12 months, and you’ll find that your gross monthly income is $5,000.
If you take your monthly debt payments ($3,000) and divide them by your gross monthly income ($5,000), you’ll get a debt-to-income ratio of 0.60, or 60%.
Why Does Your Debt-to-Income Ratio Matter?
Your debt-to-income ratio matters for a few reasons, but the most important is the fact that it can hurt your chances of getting a mortgage — even if you earn a high salary and have great credit. More than a quarter (28%) of all mortgage denials in 2016 were due to high debt levels. (It probably doesn’t help matters that more and more young home buyers are saddled with student loan debt.)
According to the CFPB, a debt-to-income ratio of 43% or below is typically required for a qualified mortgage. A large lender may be willing to offer you a home loan with a slightly higher debt-to-income ratio, but that’s after the lender makes a reasonable, good faith effort to determine that you can afford to repay the loan.
If your debt-to-income ratio is too high, you may not be able to qualify for other types of loans, either, like a personal loan or a car loan. And, even if you do qualify, you may be stuck paying a higher interest rate or with a loan with less-than-stellar terms.
What Debt-to-Income Ratio Should You Aim For?
If you’re angling for a debt-free lifestyle, then your ideal debt-to-income ratio should be zero. But since all your monthly debt obligations including housing are factored in, reaching that milestone is fairly unlikely for most of us.
While the “ideal” debt-to-income ratio can vary from lender to lender, most banks agree that a debt-to-income ratio of 35% or less is a good goal to shoot for. At that point, you’ll have some wiggle room left in your budget, even after you’ve paid your essential bills.
If your debt-to-income ratio is in the 36% to 49% range, however, Wells Fargo says you have “room to improve.” You may be managing your debt okay at that point, but you should strive to lower your debt-to-income ratio so you’re in a better spot if some unforeseen expenses crop up. If you’re looking to borrow at this range, Wells Fargo also says that lenders may ask for additional eligibility criteria.
What if Your Debt-to-Income Ratio Is Too High?
Whether you want to get a mortgage one day or plan to borrow money, everyone agrees that a debt-to-income ratio of 50% or more is just too high.
“With more than half your income going toward debt payments, you may not have much money left to save, spend, or handle unforeseen expenses,” writes Wells Fargo. With so much debt at this point, lenders may also limit your borrowing options: They want to be confident that you’ll be able to repay your loan, on top of all your other obligations.
If your debt-to-income ratio is too high and you want to bring it back down to Earth, here are some steps you can take today:
Earn more money.
When lenders calculate your debt-to-income ratio, they take your monthly debts and divide that total by your gross monthly income. For that simple mathematical reason, raising your income will inevitably lower your debt-to-income ratio, even if nothing else changes.
While earning more money isn’t a strategy that will work for everyone, it can help you lower your DTI to a reasonable level while providing more cash to help with the other tips on this list. If you can’t get a raise or more hours at work, you can always consider a part-time job or a side hustle. There are even side hustles you can do in your spare time along with jobs you can do from the comfort of your home.
Pay down unsecured debts.
The flip side to that mathematical equation is to reduce your debts. This is rather obvious, but it works: If some back-of-the envelope calculations show that you’re over that 43% DTI ratio, paying down a credit card balance or paying off a car loan before you apply for a mortgage might help you lower your debt-to-income ratio enough to qualify.
This strategy can also improve your life by leaps and bounds. By paying down unsecured debts like credit card balances and personal loans, you’ll not only lower your debt-to-income ratio; by eliminating the interest payments, you’ll give yourself a raise as well, improving your cash flow and freeing up more cash to save and invest.
Cut your spending.
If you’re spending too much each month and living paycheck-to-paycheck, it can help if you track your spending for a while. To do this, keep track of receipts or monitor your monthly bank statements at least a few times per week. Then, at the end of the month, tally up all your expenses in common categories like food, utilities, insurance, entertainment, and transportation to see where you’re at.
Once you track your spending for a month, you can figure out areas of your budget where you may be spending too much. It’s far too easy to overspend on food and dining out, for example, but this is one area where it’s fairly easy to cut your spending if you’re disciplined enough. Then, take that savings and pay off some balances to lower your debt levels.
Stop using credit.
Finally, you’ll want to stop using credit cards or borrowing money in any other fashion if you hope to lower your debt-to-income ratio. To get out of debt or reduce how much you owe, you have to stop digging!
If you’re using credit cards for all your purchases, now is a good time to stash them away and switch to debit or cash instead. Also look for other ways to reduce your reliance on borrowed money, such as keeping the car you have instead of upgrading every few years. If you can focus on paying down debt while also avoiding new debts, you will make a difference in your debt-to-income ratio over time.
Your debt-to-income ratio can sabotage your attempt at home ownership, even if you make a good income, have good credit, and you’re paying all your bills on time. However, it’s also an area where you have the power to make a change.
If you can’t buy a home or get a loan because your debt-to-income ratio is too high, take it as a sign that you’re over-leveraged, borrowing too much money for your income.
Focus on paying down debt for a while, and your debt-to-income ratio will drop. But, you may also find that you enjoy other benefits of having less debt, such as having more freedom and having more cash to save each month.
Holly Johnson is an award-winning personal finance writer and the author of Zero Down Your Debt. Johnson shares her obsession with frugality, budgeting, and travel at ClubThrifty.com.