When you think of mortgage approval, you probably think of your credit score. While this is one of the most important factors in your loan approval, there is one more factor that speaks volumes – your debt-to-income ratio.
This ratio is what tells lenders what you can afford. It lets them know if you are already in over your head in debt or if you are able to afford the potential mortgage. Now that you know the importance of this ratio, it’s time to learn what goes into it.
What is the Debt-to-Income Ratio?
First, let’s look at the definition of the DTI. It’s the total of your bills divided by your gross monthly income. Lenders will look at two different versions of your debt-to-income ratio, though. They will look at your front-end ratio, which is your new housing payment divided by your gross monthly income. They will also look at your total debt ratio, which is all of your debts divided by your gross monthly income.
Figuring Out Your DTI
In order to determine your DTI, you need to know your gross monthly income. If you get paid on salary, this is easy. Let’s say you make $100,000 per year. Your gross monthly income is $100,000/12 = $8,333.
If you are not paid a salary, you will have to figure out your gross monthly income another way. If you are paid hourly and work 40 hours a week, you can multiply 40 by the hourly rate. You can then multiply that number by 52 weeks and finally divide by 12 to get your gross monthly income.
If you are paid any other way, you can use your adjusted gross income on your tax returns to determine your annual salary. Dividing that number by 12 will give you the gross monthly income.
Totaling Up Your Debts
Now comes the fun part – totaling your debts. Just what do you include? The good news is that not every single bill you pay or thing you buy each month counts towards your debt ratio. Lenders only care about the debts that get reported on your credit report. The only exception is your utilities. The lender will estimate the cost of the monthly utilities to include in your debt ratio (in some cases).
A few common examples of debts that get included are:
- Credit card payments
- Car payments
- Student loan payments
- Personal loan payments
- Installment loan payments
Of course, you will then need to add the new mortgage payment. The lender will include the principal, interest, real estate taxes, homeowner’s insurance, and association dues in this total. Your lender can give you a good estimate of these numbers to determine your DTI.
What Does Your DTI Need to Be?
The next question is just what is the maximum DTI? This will depend on the lender and loan program. Generally speaking, the following debt ratios prevail:
- Conventional loans – 28% front-end ratio and 36% back-end ratio
- FHA loans – 31% front-end ratio and 43% back-end ratio
- VA loans – 43% back-end ratio
- USDA loans – 29% front-end ratio and 41% back-end ratio
No matter the loan program, though, if it is conventional or government-backed, the maximum DTI is 43% no matter the exceptions a lender grants. This is what constitutes a Qualified Mortgage. This protects lenders and their investors from giving borrowers mortgages they cannot afford. It’s another way to prevent another housing crisis moving forward.
Your debt-to-income ratio is an important figure, not only for the lender, but for you too. It helps you understand how much of your income will already be spoken for and be unable to help you cover the cost of living. Only you know what you are comfortable paying, so make sure you pay close attention to this figure and how the new loan figures into your income.