When you’re applying for a mortgage loan to buy a house or refinance, lenders look at many important factors, including a borrower’s credit score, the amount of money they’re putting down, and how much money they have in the bank. But there is no determining factor more important than a borrower’s Debt-to-Income Ratio, or DTI as its commonly called in the lending industry. In fact, DTI is the most accurate indicator of a homeowner’s ability to repay their mortgage comfortably every month.
While your Debt to Income Ratio may seem self-explanatory, there are actually some fine points and distinctions that are important to understand so that you’ll be prepared for the mortgage lending process and approved for a great loan.
Debt-to-Income Ratio defined:
Your debt to income ratio is a mathematical measure of your monthly payments on debt obligations divided by your gross monthly income.
Why is DTI such an important factor for lenders?
Lenders use every available shred of data on borrowers and mortgages for one reason: to predict how likely the applicant will be to repay the loan. By doing so, they are trying to reduce the number of mortgage defaults and eliminate their risk as much as possible. Research shows that DTI is a proven method of determining a borrower’s likelihood of repaying their mortgage, and the lower the DTI, the more secure their loan is.
Which debts are included?
Debt obligations that are included in DTI calculations include:
- Credit card payment
- Auto loan payments
- Student loan payments
- Installment loan payments
- All other monthly payments for revolving debt
- Court-ordered alimony, child support and other judgments with set payments
- Mortgage payments for other homes or rental properties
- The proposed new mortgage payment, including principal, interest, taxes and insurance (PITI) for one version of DTI (called the back-end ratio.)
It’s important to note what’s NOT included in DTI:
- Cell phone bills
- Utility bills
- Food, fuel, and other living expenses
- Another other bills that don’t show up with set monthly payments on the credit report
- Most medical debt
Calculating debt to income ratio:
To determine your DTI, simply add up the monthly payment for all of these debt obligations we listed above and divide it by your monthly income.
It’s important to note that when factoring your income to use in the equation, lenders use your gross income (before taxes and social security, etc. are taken out.)
Another distinction is that banks and lenders use a Qualifying Rate that represents the true PITI mortgage payment, even if the loan in question has a period with interest only payments, is adjustable in the future, or less commonly now, a negative amortization loan.
With that fine print out of the way, calculating DTI is fairly simple. For example:
Monthly debts:
$1,500 PITI for proposed new mortgage
$100 auto loan
$400 credit card debts and student loan added together
Total monthly debt payment = $2000.
If your gross monthly income is $6000, then your debt-to-income ratio would be (2,000/6,000) = .33 percent, or 33%.
Back-end and front-end DTI:
There are actually two separate DTI calculations lenders use, back-end DTI ratio for all of your monthly liabilities divided by income, and front-end DTI ratio for only your proposed monthly housing payment (including taxes and insurance) divided by income. Since front-end DTIs don’t factor in the large mortgage payment, they are much lower percentages than back-end ratios.
What DTI do lenders look for?
As a general rule, lenders want to see a maximum back-end (including mortgage payment) DTI of 43% or less. That’s also the highest ratio allowed for a borrower who wants to get a Qualified Mortgage.
An ideal DTI is below 36% for a back-end ratio, and lower than 28% for the front-end ratio of debt of just housing payments.
Are there exceptions to the 43% DTI guidelines?
The 43% is a common requirement and general standard in the lending industry, but there are plenty of exceptions. For instance, some lenders may be able to look at mitigating factors like a larger down payment, cash reserves, a super credit score, etc. when weighing their approval decisions.
For USDA loans, the max DTI ratios are set at 29/41; VA loans that are manually underwritten have a maximum debt-to-income ratio of 41%; for common FHA loans that are manually underwritten the max debt ratios are 31/43, but for other FHA programs, “stretch ratios” of 33/45 may be allowed.
Some banks allow for special parameters to allow borrowers to qualify based on common sense underwriting. For instance, some credit cards that work like installment loans (American Express) dictate that a borrower pays off the balance entirely every month, or other credit cards are tied to work expense accounts, so they allow those debts to be excuded from the DTI calculations.
But many lenders do stick to the 43%-and-under DTI rule because it is a sound standard and falls under the classification of a Qualified Mortgage under the Consumer Finance Protection Bureau’s new rules.
How can a borrower improve their Debt-to-Income Ratio if it’s too high?
There are only two ways to lower your DTI: by dropping your monthly debt payments, or increasing monthly gross income (or both.) While you don’t want to wait until the loan application process to try and impact your income or debts, it is often possible to lower a DTI to acceptable ranges with a little planning, organization, and diligence.
For instance, over-time at work or an additional part-time or seasonal job may increase your income if structured correctly on the loan application and supporting documentation, and paying off some credit cards, an installment loan, or even consolidating debt may lower payments. But you should never do these things without asking us first, since making these changes could also do harm to your credit score or raise red flags with lenders that are impossible to overcome.
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Of course borrowers just know that they want to purchase their dream house or save money by refinancing – and that’s exactly why using an experienced and knowledgeable mortgage broker is critical to getting approved for the best possible mortgage loan with the lowest rate!