Your debt-to-income ratio can lead to your mortgage application being rejected

If you need to take out a mortgage to buy a home, make sure your financial situation is sound, especially your debt-to-income ratio.

Your debt-to-income ratio is all of your financial debt payments divided by your gross monthly income. It's the “number one way” lenders measure your ability to manage your monthly loan payments, according to the Consumer Financial Protection Bureau.

Debt-to-income ratio was the most common reason for a mortgage application denial, at 40%, according to the National Association of Realtors' 2024 Home Buyers and Sellers Profile Report.

The report found that other factors that influenced homebuyers in the approval process were a low credit score (23%), unverifiable income (23%), and not having enough money in reserves (12%).

NAR surveyed 5,390 buyers who purchased a primary residence between July 2023 and June 2024, and found that 26% of homebuyers paid all cash — a new high.

Repeat buyers who have acquired record home equity in recent years have led the trend, according to NAR.

But for those who need to borrow to buy, lenders and institutions look at your debt-to-income ratio to see if you might have trouble adding a mortgage payment on top of your other debt obligations.

“The higher your debt-to-income ratio, the less likely they will feel comfortable lending to you,” said Clifford Cornell, a certified financial planner and associate financial advisor at Bone Fide Wealth in New York City.

It's a factor that affects home applicants of all income levels, said Shweta Lawande, a certified financial planner and principal advisor at Francis Financial in New York City.

“If you're high-income, you may not have a problem saving for a down payment, but that doesn't mean you have a good debt-to-income ratio,” she said.

Here's what you need to know about your debt-to-income ratio.

If you're looking to apply for a mortgage, the first step is to know your current DTI ratio, Lawande said.

Take your total required monthly debt payments, such as your monthly student loan or car loan payment. She said: Divide this amount by your total monthly income. Multiply the result by 100 and the DTI will be expressed as a percentage.

A DTI ratio of 35% or less is usually considered “good,” according to LendingTree.

But sometimes lenders can be flexible and approve applicants with debt-to-income ratios of 45% or higher, Brian Nevins, director of sales at Bay Equity, the mortgage lender owned by Redfin, recently told CNBC.

One way to figure out your housing budget is called the 28/36 rule. This guideline states that you should spend no more than 28% of your gross monthly income on housing expenses and no more than 36% of that total on all debts.

For example: If someone earns a gross monthly income of $6,000 and has $500 in monthly debt payments, they can afford a mortgage payment of $1,660 per month if they follow the 36% rule. If the lender accepts up to 50% DTI, the borrower may be able to get a monthly payment of $2,500 on the mortgage.

“That's the maximum for most loan programs that someone can get approved for,” Nevins told CNBC.

You can improve your debt-to-income ratio by either reducing your current debt or increasing your income.

If you have existing debts, there are two methods you can work to pay them off, experts say: the so-called “snowball method” and the “avalanche method.”

The snowball method is about paying off the smallest debt balances first regardless of the interest cost, which can seem less onerous, said Shawn Williams, a private wealth advisor and partner at Paragon Capital Management in Denver, the No. 38 firm on CNBC's 2024 plan. List of 100 financial advisors.

“One is what's best on a spreadsheet, and the other is what makes a person feel best from a behavioral finance standpoint,” Williams said.

However, “Avalanche is better because the real cost of debt is your interest rate,” he said, as you're more likely to pay off debt faster.

Let's say you have student loans with a 6% interest rate versus a current credit card balance with a 20% interest rate. If you have credit card debt, consider addressing that balance first, Cornell said.

“Whichever borrowing costs you the most is the one you want to pay off as quickly as possible,” he said.

If you've already done what you can to consolidate or eliminate existing debt, focus on increasing your income and avoiding other large purchases that may require financing, Laundy said.

“The goal is to maintain cash flow as much as possible,” she said.