When you apply for a mortgage, your lender takes an in-depth look at your finances to determine if you qualify for the loan. In addition to your credit rating and income, one of the factors your lender will take a closer look at is your debt-to-income ratio.
The debt-to-income ratio helps lenders determine how much home you can afford by showing the percentage of your monthly income that is spent on your unpaid debts. In this article, we’ll explain exactly what the debt-to-income ratio is, how it applies to mortgages, and how you can lower yours to better qualify for a mortgage.
What is the debt to income ratio?
Debt to Income Ratio (DTI) is the percentage of your gross monthly income that goes towards your current debt. Rather than looking at your total debt amount, the ratio only takes into account your monthly debt payments based on your monthly income.
The DTI is one of the most important measures of your financial health, and it is commonly used by lenders to determine your creditworthiness. In general, a low DTI shows that only a small portion of your income is spent on debt, leaving more money available for savings, expenses, and other financial obligations, such as paying a mortgage. mortgage.
How is the debt-to-income ratio calculated?
Calculating your DTI requires dividing your minimum monthly debt payments by your gross monthly income. It is important to note that gross income includes all of your income, before any taxes or expenses are deducted.
Suppose you have a gross annual income of $ 60,000 per year, which breaks down to $ 5,000 per month (before taxes). You have a student loan with a monthly payment of $ 200, an auto loan with a monthly payment of $ 275 and a credit card balance with a minimum monthly payment of $ 90.
Your total debt repayments are $ 565 per month. When you divide that by your gross monthly income of $ 5,000 per month, you will find that you have a DTI of 11.3%. When applying for any type of loan, a lender is likely to look at this number and see how new debt would affect them. Going into debt again will increase your DTI, while reducing your debt or increasing your income will decrease your DTI.
If you’re considering buying a home, do the math to calculate your debt-to-income ratio so you know if you’re likely to qualify for a mortgage, or if you’ll need to spend a little more time preparing your finances.
DTI and mortgages
The DTI is one of the most important metrics that mortgage lenders take into account when determining whether a person qualifies for the home loan they are applying for. This is partly explained by the regulatory measures put in place after the financial crises of the late 2000s, according to Robert heck, vice president of mortgages in the online mortgage market Morty.
âAt this point, almost all loan programs have some concept of repayment capacity, which is built into the lender’s process for assessing a consumer,â Heck explains. âDTI is one of the most important metrics for repayment capacity. When I say ârepayment capacityâ, it is simply the lender’s best assessment of a borrower’s ability to make ongoing payments after taking out the mortgage. “
The DTI that a lender will need for a mortgage loan depends on several factors, including the type of loan you take out. Some government loans, like FHA or USDA loans, may have specific DTI requirements. In addition, other measures of your financial health may cause the lender to charge a lower than normal DTI. In general, having a lower DTI will help increase your chances of being approved for a mortgage.
According to Heck, there are many other factors that go into determining the maximum DTI, including the down payment and the home the buyer wants to buy. A good rule of thumb for the maximum recommended DTI is 50%, he says. âBut if there are additional risk factors such as a lower down payment or a lower credit score, the maximum DTI ratio can drop to 45%, 43% or 36%,â he adds.
Lenders are also likely to factor in your initial DTI, which is the percentage of your monthly income spent on housing. This will usually be a different number of your back-end DTI, or the percentage of your income that goes to all of your debts. Lenders generally want your initial DTI to be less than 28%.
Should You Apply For A Mortgage With A High DTI?
Average non-mortgage debt per person in 2021 was $ 25,112, according to credit bureau report Experiential. Unfortunately, these high debt balances can make it more difficult to qualify for a mortgage. You might wonder if it’s worth applying for a mortgage with a DTI that is near the high end of the range allowed by your lender.
First of all, know that there is little harm in just asking for pre-approval to see if you might qualify for a loan and what amount you might qualify for. Although there will be a thorough investigation of your credit report which might lower your credit score by a few points, it can provide you with valuable information.
Then think about your monthly budget with a mortgage payment. The DTI requirements are there to reduce the risk to the lender, but they also help protect you, the borrower, against any overruns.
“You don’t want to stretch too much and become poor, that is when you buy as much house as you can, then it takes the majority of your income each month and you are strapped for cash or you can’t save for other purposes â, says Brittney castro, the in-house CFP for the financial planning app Mint and the founder and CEO of Financially Wise.
See how your budget would change after taking out a mortgage and how much your housing costs would increase. Remember to include other costs associated with home ownership, such as maintenance expenses, property taxes, and home insurance. You will have to decide for yourself if you are comfortable with the results.
How to lower your DTI ratio
If your DTI is preventing you from qualifying for the mortgage you want, there are steps you can take to reduce it:
Pay off the debt
One of the most effective ways to reduce your ITD is to pay off your debt. While it’s often easier said than done, reducing your debt amount can help you lower your monthly payments, and therefore the percentage of your monthly income that goes into debt.
In addition to lowering your DTI, paying off your debt can also improve your credit score by reducing your credit utilization rate, which is your total debt divided by your total available credit. A higher credit score could help improve your chances of qualifying for a mortgage or getting a great interest rate.
Increase your income
Another way to lower your DTI is increasing your income. Not only will you have a higher gross income for the calculation, but you will also have the opportunity to spend more money on your debt, which can further reduce your DTI.
You can increase your income in a few ways, including changing jobs, negotiating an increase in your current job, working overtime, or taking a second job or a side job.
Lower your monthly payments
The DTI doesn’t take into account the total amount of your debt – it only takes into account the amount of your income allocated to your debt each month. By reducing your monthly payments, you can reduce the percentage of your income used for debt.
There are many ways to lower your monthly payments, including refinancing your loans or negotiating the interest rate on your debt. While it is possible to negotiate your interest rate on credit cards, installment loans, such as personal loans, car loans, or student loans, will likely require refinancing to adjust the rate.
Reduce your non-essential expenses
âWatch where your money is going each month and cut as much as you can,â advises Castro. âA lot of times we find we are paying for things like subscriptions that we no longer need. Really getting a handle on your monthly numbers, your spending, your spending, is going to come in very handy, as you are going to have to make changes once you are home and incur additional expenses.
Freeing up that extra money in your monthly budget means you’ll have more availability to pay off your debts. And the sooner you can pay off your debts, the faster you can reduce your DTI to buy a home.
Increase your deposit
When lenders calculate your DTI, they consider the impact of a mortgage loan on your finances and aim to keep your DTI with your mortgage below a certain level. According to Heck, you can lower your DTI when you own a home by making a larger down payment, which will result in lower mortgage payments each month.
“If I’m going for affordability, one of the best things you can do is start saving and either pay off existing balances as you save or save more so you can invest more in your business. house, which would reduce your DTI, âHeck said. âThese are two long-term solutions, but it’s really the best approach to affordability. “