Borrowers can do a number of things to prepare themselves financially to buy a home. At the top of that list is controlling how much debt you have at any given time. The debt-to-income ratio is an important tool lenders use to measure a borrowers debt level and is one of the important factors considered when determining if a borrower is qualified to buy a home. For anyone preparing to purchase a home in the next twelve months it’s helpful to know what your debt-to-income ratio is. This article will help borrowers to understand the debt-to-income ratio for a mortgage.
Why do I need to know my debt-to-income ratio?
It is extremely important to know your debt-to-income ratio before purchasing a home and whether it is too high according to mortgage guidelines. “Knowing your debt to income ratio is just as important as knowing your credit score when you are about to purchase a home” says Stephen Khan, mortgage loan officer in Phoenix, Arizona. Having a high DTI can have an impact on being approved for a mortgage loan so it is extremely important to act wisely on managing your debt levels.
What debts are included in the Debt-to-Income Ratio calculation?
The debt-to-income ratio is calculated by adding up all of one’s minimum monthly debt payments and dividing that number by one’s gross monthly income. The debts that are included in this calculation can include credit card payments, car payments, any installment loan payments, student loan payments, alimony or child support payments and of course one’s housing payment. To qualify for a mortgage loan, borrowers ideally will have a debt-to-income ratio of 45% or less.
How is a Debt-to-Income Ratio Calculated for Mortgage?
Here is an example of how to calculate one’s debt-to-income (DTI) ratio. If you have monthly debts of:
Rent or Potential Mortgage payment: $1,500
Auto Loan: $300
Credit card Minimum Monthly Payments: $200
Total Monthly Debt Payments: $2,000
Gross Monthly Income: $6,000
Calculate the debt-to-income ratio by dividing the $2,000 monthly debt payments by the $6,000 total gross income to arrive at a debt-to-income ratio of 33%. Assuming the rest of the loan application looks good, this is a very manageable DTI ratio and would set the borrower on the right path to being approved for a home loan.
Types of Debt-to-Income Ratios
There are two types of debt-to-income ratios that lenders use when they evaluate a mortgage application:
* Front end ratio: this is also known as the housing ratio and this ratio indicates what percentage of one’s income would go towards housing expenses, including your proposed monthly mortgage payment which includes property taxes, homeowner’s insurance and homeowner’s association dues (HOA). For most lenders, the ideal front end ratio is 28%.
* Back end ratio: this ratio shows what portion of a borrowers income is required to pay all of one’s monthly debt obligations. This ratio is calculated by using the minimum monthly payments on credit card bills, car loans, personal loans, student loans, child support and any other debt that appears on a credit report. The back end ratio also includes one’s proposed mortgage payment including property taxes, homeowners insurance, and any HOA dues. For most lenders, the ideal back end ratio is 36% or lower, but borrowers can be approved with DTI’s as high as 45% in many cases on a Conventional loan.
FHA vs Conventional Debt to Income Ratio requirements
For FHA mortgage loans most lenders have a target back end ratio requirement of 43% that applies to most borrowers. But this is mostly used as an initial target before making adjustments on a borrower by borrower basis. When a borrower has their own down payment funds available, FHA guidelines allow one to have a higher debt to income ratio for qualification purposes. Speak to your lender to find out what their FHA lending guidelines allow.
For Conventional loans, the DTI can go as high as 45% to meet standard conventional loan mortgage guidelines. But while the debt-to-income ratio guidelines might be generous with a conventional loan, the tradeoff is that credit requirements are sometimes more stringent for some borrowers with past credit issues. The best way to learn if any past credit issues will affect your loan application is to work with a loan officer well before you are ready to buy a home so you have time to fix anything that may appear on your credit report.
As we said earlier, be very careful to actively manage your debt level leading up to any home purchase. Try to pay down any outstanding debt so your goal is to have a DTI of 43% or less when you apply for a mortgage.
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