When you’re thinking of buying a home, it’s important to be familiar with the factors that would affect your chances of approval — considering you’re buying the house with a mortgage.
Income, employment, financial support obligations, and credit history aren’t the only proof that you are financially capable of staying on track of your mortgage payments. You also need to show that your debts don’t eat up most of your income. This is so you don’t sacrifice your mortgage budget for other expenses.
But what exactly is the debt-to-income ratio, and what percentage should you have, so lenders will consider it good?
How to Calculate Debt-to-Income Ratio (DTI)
The debt-to-income ratio is the result when you divide your monthly debt payments by your monthly gross income. Debt payments include your monthly car amortization, credit card payments, mortgage, student loan, and other fixed debts. If you have personal debts to your family and friends, those don’t count.
As an example, if your car amortization is $500/month, credit card payments are $900/month on average, student loan is $400/month, and mortgage for your current home is $1,100/month, then your monthly debt expense is around $2,900. Divide that by your monthly gross income — let’s say $6,000 —and multiply it by 100, you have yourself a DTI of 48.33%. Don’t forget that your monthly gross income is your income before taxes and other deductions.
In addition, it doesn’t matter what type of debt you have as each debt has equal weight in the DTI equation. When you’re listing your debt, make sure not to include the service fees in the total. You can use online debt-to-income ratio calculators if you want to be sure of the calculation.
Difference Between the Debt-to-Income Ratio Front-End and Back-End
You might have heard of the front-end DTI and the back-end DTI. To put it clearly, lenders generally consider your “back-end DTI” when applying for a mortgage. The back-end DTI is the portion of gross income that’s allocated to pay all your debts, while the front-end DTI is the portion of your gross income that’s allocated to pay for your existing home expenses (e.g., mortgage, home insurance, and home owner’s association fees).
For example, if your existing housing expense sums up to $700/month, and your gross income is $6,000, then your front-end DTI is 11.67%. It is expected that the front-end DTI is lower than the back-end DTI; that’s why lenders allow a lower standard for front-end DTIs as compared to back-end DTIs.
What Debt-to-Income Ratio Do Lenders Look For?
DTI limits vary per lender. Usually, the maximum DTI is 43% for private capital-backed loans — a number set by the original Ability-to-Repay and Qualified Mortgage Rule (ATR/QM).
Government-insured loans such as Fannie Mae, Freddie Mac, the FHA loan, and the USDA loans are not covered by the original ATR/QM rule which means that these agencies have had the freedom to consider higher DTIs (50% or more) even from the beginning. And this is mostly true, especially when you score high in other factors such as credit score and residual income.
However, since the last quarter of 2020, a couple of amendments have been put in place for the ATR/QM rule. This includes the replacement of DTI limitations into Price-Based Limitations, which, in simple terms, mean that the 43% DTI is no longer a strict qualifying factor for private-backed mortgage loans. As much as this was risky for people who already have so much debt load, it gave Americans the chance to buy a home — an opportunity that can be life-changing.
So for Wells Fargo, for example, a 50% DTI can already be accepted, but you’ll have very limited borrowing options. To them, the ideal DTI is still 35% and below. Like the FHA, DTIs ranging from 36%-49% can be deliberated if backed by good or excellent standing in other criteria.
What Can I Do If My Debt-to-Income Ratio is Too High?
Your debt-to-income ratio is an important mortgage qualifier because it shows how much more debt can you handle. People who mostly only have student loans can still be ineligible for a median home mortgage, even if they’ve been paying rent that’s higher than the projected mortgage payment for years. Or, if they qualify, they’d only be allowed to borrow a lower amount.
So, to convince your lender that your high DTI will not hinder you from paying your mortgage fully and on time, the best things to do would be to:
- Wait until a chunk of your current debts are paid
- Increase your income and;
- Put your credit card to good use (e.g., have your family and friends pay through you) in order to increase your credit score
- Have someone, who has good credit standing, good income, and low DTI, co-sign your mortgage application
With all the factors involved in evaluating a mortgage application, it can be disappointing if the lender rejects your application after all the hard work you’ve done. If you need help navigating the mortgage application process, talk to us at HomeSoldGA. We can assist you in acquiring your dream home and help you figure out what you can do with your mortgage application.