When lenders evaluate your mortgage loan application, one of the most important numbers they will look at is your Debt-to-Income (DTI) ratio. It is a strong indicator of your ability to repay mortgage debt, and therefore how much risk you pose to the lender.
DTI allows a lender to look at a basic risk factor – do you tend to spend a lot compared to what you make? You can have a large income, but if your spending is also disproportionately large, it only takes a minor disruption to send you into a debt spiral.
There are two variations known as the front-end and back-end DTI.
A front-end DTI only considers all housing-related debt, including the mortgage payments, taxes, insurance, and homeowner's association fees. A back-end DTI also includes all of your non-housing-related regular debts and monthly expenses, such as car payments, credit card debts, child support, and student loan payments.
Lenders often consider both when reviewing your application, but the back-end DTI is usually given more attention since it is more comprehensive.
Historically, conventional loans have required a DTI of no more than 28% front-end and 36% back end, although this limit has been stretched at times. VA loans and FHA loans that have lower risk because of partial government backing can withstand higher DTI ratios, generally in the low-to-mid 40% range.
The DTI value was stretched often in the days leading up to the subprime mortgage crisis; since then, lenders, with the encouragement of regulators, have drawn back to the traditional marks. The current rules from the Consumer Financial Protection Bureau (CFPB) put a DTI limit of 43% to be a qualified loan under the new rules, giving lenders incentive to stay under that mark – although they already had significant incentive because of previous default levels. These restrictions may change in the future, however, as the CFPB is currently under attack from Republicans, who argue that its fines are levied arbitrarily and are harmful to financial institutions.
"Keep in mind [that] lenders are often willing to lend you more money than you may be comfortable borrowing," cautions Bankrate.com Chief Financial Analyst Greg McBride. "Ultimately, you're the one that's on the hook for those monthly payments."
If you find your DTI is problematic, what can you do? Asking your boss for a raise so you can buy a house is probably not going to work. Aside from that, consider the following:
- Cut Spending – Obvious, but worth emphasizing. If you have not done so already, organize your expenses into daily needs, essential bills, and wants. How many wants are you willing to give up or delay in order to buy a home?
- Control your Credit – Keeping your credit card balance low is a positive – 10% or below of your credit limit is best; 35% or above is a red flag for most lenders.
It is very important not to open any new credit accounts during this time. Not only is that greater temptation to spend, it will affect your credit score whether you use the account or not. Lenders see asking for more credit as a dangerous risk sign. The free Debt Optimizer by MoneyTips can help you consolidate your debt and reduce your interest payments.
- Scale Back Housing Goals – Perhaps you are just trying to buy too much home for the income, savings, and debt that you have. You can either consider buying a less expensive home that fits your current income, or alter your spending and saving habits with the goal of qualifying for your preferred home in the future.
- Second Job – You can raise your income level, but you have to balance the potentially brutal lifestyle against your housing goals. Is buying a larger house that important to you?
Don't go into a mortgage application ignorant of your DTI and its effects. If it is not where you need it to be, with some planning and time, you can put your DTI value in the range to get the house of your dreams – or you may have to adjust your dreams. Don't forget, if you cannot afford it but buy it anyway, your dream house can quickly become a nightmare.
MoneyTips is happy to help you get free mortgage quotes.