If you are preparing your finances to take out a home loan, your debt-to-income ratio (DTI) is one of the most important factors lenders use to determine whether the loan is approved. Mortgage companies use this metric to help them decide whether the loan is appropriate for your financial circumstances or if you are getting in over your head. A high debt-to-income ratio typically leads to a home loan denial or a significant increase in the interest rate on an approved mortgage.

Your debt to income ratio is calculated by dividing monthly expenses by your gross, pretax income. A DTI is a guide that demonstrates how much you can reasonably borrow for a home loan. However, this figure does not include monthly operation expenses such as utility bills, food budgets, or insurance premiums. A typical home lender will accept a DTI of 36% or less to approve a loan, though there are some exceptions to that rule.

Two Types of Debt to Income Ratios

There are two types of debt-to-income ratios that home lenders use to decide whether to offer you a mortgage, how much they feel comfortable lending you, and the interest rates that will apply to the loan.

Front-End Ratio

Also referred to as a “household ratio,” a front-end ratio considers the percentage of your monthly income that will go towards regular expenses after the home is purchased. The front-end ratio takes into recurring costs for property taxes, insurance, mortgage payments, homeowners’ association fees, and other associated homeowner expenses.  The total of your housing costs is divided by your monthly income to determine a front-end debt to income ratio used in the mortgage approval process. 

Back-End Ratio

The back-end debt to income ratio also considers other debts, including the above monthly housing costs, plus loan and car payments, credit card debt, and any other outstanding loans that add to your debt. Back-end ratios are generally higher since they include all of your monthly debt and financial obligations.

Which Type of Debt to Income Ratio is More Important?

Your back-end debt to income ratio will reveal more about your financial status to home lenders than a front-end ratio can provide, as it takes more of your debt into account. If you apply for a conventional home loan through a bank or mortgage lender, your back-end DTI will play a more prominent role. A front-end DTI below 28% with a back-end ratio below 31% is ideal for conventional loans.

Loans through a government program or other unconventional needs will be more scrutinized. Lenders for FHA loans, for example, will look at both the front-end and back-end debt to income ratios and have higher standards than a conventional mortgage.

In addition to the direct impact a debt to income ratio can have on a home loan, keeping your DTI as low as possible will help keep your credit score down, which will also help secure a lower mortgage interest rate.

Ways to Lower Your Debt-to-Income Ratio

The two ways of lowering your debt to income ratio are increasing your income or decreasing your debt. The following are methods you can use to establish a more favorable debt-to-income ratio to present to prospective home lenders.

Pay Off Loans Ahead of Schedule

You have set up a payment plan for long-term debts. If you pay more than the minimum payments and pay off the debt sooner than scheduled, it offers you the chance to reduce the amount of debt calculated in your mortgage application.

Whether you use a debt avalanche strategy that targets debt with the highest interest or a snowball debt approach that starts with the smallest balances, the quicker you reduce your overall debt, the better your chances are obtaining a mortgage that fits within your means. 

Get a Raise, Second Job

Other than finding a higher-paying job, there are several ways you can increase your income to lower your debt to income ratio. The worst your boss can do if you request a raise is say no. Get a part-time job or create additional income sources by putting in some hours driving for a ride-sharing company. Have a yard sale or put some of your most valuable items up for sale on eBay or Facebook Marketplace. Any increase in your paychecks can help to offset your debt when applying for a home loan.

Lower Interest Rates with Balance Transfer

If you qualify, you can transfer all or a portion of your debt to a zero-interest credit card for a specified timeframe during a promotional period. This will allow you to pare down or pay off the balance of your debt quicker and motivate you to take advantage of the opportunity while it exists. If you cannot keep up or pay off the balance by the time the promotion ends, regular interest rates can force higher monthly payments than before and lower your debt to income ratio.

Refinance Debt

Lowering your interest rates and monthly payments will improve your debt to income ratio for home lenders. Refinancing a student loan or other debt is an effective way to lower your DTI if you qualify for a lower interest rate loan with lower payments. There is a range of online lenders that offer lower rates to borrowers looking to refinance debt.

Waiting to Lower DTI Before Applying for Home Loan

The methods to improve debt-to-income ratios for home lenders can take time, but they do work. If you can afford to wait and are confident you will be able to make the necessary steps to lower your DTI, it can put you in a far better position to get a better deal for your new home. Take the time to calculate the difference improving your DTI can make on your mortgage you can secure, and you will see the importance and impact your debt-to-income ratio can have on your home loan.