What is a debt-to-income ratio, and how does it impact your mortgage application?

A debt-to-income ratio (DTI) compares the amount of money you earn to the amount of money you owe to various lenders and credit card providers. It’s used by lenders to judge whether you can repay your mortgage comfortably or not.

Generally, a DTI over six times your income is considered risky by many lenders and could lead to your mortgage application being rejected in some cases. On the other hand, if you have a lower debt-to-income ratio, lenders will look at your application more positively. Lenders will see a low DTI as indicating you’re more likely to repay the loan as your money is not tied up in other debts.

Calculating your debt-to-income ratio is simple, and it can help you keep your debts at a manageable level. To figure out your DTI, start by calculating your total yearly income. For this purpose, you may consider your gross annual income and any other income, such as rental income, any overtime, commission, contractual payments, etc., before tax. If you’re self-employed, your total income would be your net profit before tax with any acceptable add-backs.

The next step is calculating your debts and liabilities. The types of debts included in the calculation of your DTI include:

• Personal loans
• Credit card limits
• Any kind of buy now pay later services
• Existing mortgage debts
• Tax debt
• HECs or HELP debt

Joint loans are considered for their total value irrespective of the percentage you may own.

Now divide your total debts and liabilities by your gross income, and the figure you get is your DTI.

Here’s a scenario-based example for you to understand this calculation better. 

Let’s say a couple earns a combined yearly gross income of $150,000. They recently decided to purchase a property and figured they'd need to borrow $500,000 to fund it. They also have a joint outstanding car loan of $10,000, and each have a credit card with a monthly limit of $2,000. Therefore, their total liabilities are:

• $500,000 for the new mortgage
• A car loan of $10,000
• Combined credit card limit of $4,000
• Total debt: $514,000

To calculate the DTI, they would then divide the total debt ($514,000) by their total income ($150,000), which equals to a DTI of 3.43.

This means that the total debt as joint applicants for a home loan is 3.43 times more than their combined income. Lenders will assess the DTI together because it is a joint application.

Using the same example, let’s say the couple want to borrow $600,000 for a home. This will increase the total debt to $614,000, and the DTI would increase to 4.09 times the total income.

What is the ideal Debt-to-Income Ratio to qualify for a mortgage?

Though most lenders use the debt-to-income ratio to assess your repayment capacity, each has its own DTI level they consider safe. That being said, many lenders consider you safe for lending if your DTI is below six or below six times your total income.

If you have a higher level of debt, many lenders will consider you a high-risk borrower and might refuse to lend you money. They believe you’re more likely to struggle if the interest rates were to rise suddenly or there was a sudden change in your financial situation.

If your debt-to-income ratio is under 3.6, it illustrates a low amount of credit or debt and an ability to manage your debts successfully. Lenders tend to see you in a favourable light when you have a low debt-to-income ratio. They’re more likely to offer you more competitive rates and fees than borrowers with a high DTI.

In addition to your debt-to-income ratio, some non-bank lenders also use the net service ratio to determine your repayment capacity. The net service ratio is calculated by subtracting your expenses and liabilities from your after-tax income. It gives lenders an estimate of how much you might be able to repay towards the new mortgage you plan to take up.

How can you reduce your debt-to-income ratio?

If you have a high debt-to-income ratio, it means that your debts are substantially more than your income. This should be seen as a red flag that you may be taking on too much debt, and it would help to take some steps to keep it at a more manageable level. A high debt-to-income ratio may also lead to you having your home loan application rejected.

Here are some steps to bring down your debt-to-income ratio before applying for a home loan:

1. Increase your income by working an extra shift or taking up a part-time job.
2. Use a debt reduction strategy to reduce your debts.
3. Make a budget to control any frivolous spending and increase your disposable income. This will not directly affect your debt-to-income ratio. It will eventually help reduce your debts as you can apply your additional savings towards paying down your debts faster. 
4. Consider reducing the limits on any credit cards.
5. If you have an outstanding mortgage, you might consider refinancing to a lower interest rate to boost your savings. 

If you have a high DTI ratio but enough disposable income to repay your home loan, it could help to speak with a mortgage broker and discuss your situation. Once a broker is satisfied that you’re able to meet the repayments on a new mortgage without any hardships despite a high DTI, they can use their relationship with various lenders to help increase the chances your home loan application will be approved. Some lenders also have higher DTI caps, and your broker can help you with home loan deals from lenders that are more likely to approve your mortgage application. 

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