Debt-to-Income Ratios and Home Buying
Most potential homebuyers are familiar with the importance of credit scores and job security in qualifying for a mortgage. Another factor that many homebuyers overlook is the connection between a debt-to-income ratio and home buying. This figure, also known as DTI, reflects the portion of your gross monthly income that must go toward paying recurring monthly debts. Debt-to-income ratios are used throughout the mortgage industry to determine how much house a borrower can afford.
How Debt-to-Income Ratios are Calculated
As a general rule, DTI is calculated by dividing your monthly debts by your pretax income. The majority of lenders are looking for a DTI of 36 percent or less. There are two variations in the way DTI can be calculated. The first is called a front-end ratio or household ratio. This calculation uses the amount of proposed home-related expenses, including the monthly mortgage, insurance, property taxes, and association fees, divided by your pretax income. The back-end ratio also includes other recurring monthly debts, such as personal loans, car loans, and student loans. It is important to note that none of the calculations take into account living expenses such as food, transportation, and utilities.
Which Type of DTI Matters Most?
While both front-end and back-end debt-to-income ratios are important, lenders do tend to focus more on the back-end ratio, especially when it comes to conventional mortgages that are not backed by a government program. Most lenders prefer a front-end ratio below 28 percent and a back-end ratio under 36 percent. When you apply for an FHA or another type of nonconventional loan, the lender will still consider both ratios; however, they may allow your DTI to be slightly higher than with a conventional mortgage. You may be able to get approved for these types of loans even if you have a front-end DTI of 31 percent and a back-end DTI as high as 43 percent.
Understanding the Big Picture
Your goal should be to have as low of a debt-to-income ratio as possible, ideally below 36 percent. This will improve your overall credit score and even help you get a better interest rate on your loan. Even if your DTI is good enough to qualify for the mortgage, you want to make sure that you can still afford your basic living expenses. You also need to take into consideration that your DTI is based on gross income, not what you actually receive in your paycheck.
Tips for Lowering Your DTI
If your DTI is over 50 percent, you may want to consider postponing your home purchase so that you can focus on getting your finances in shape. This includes paying off as much debt as possible and avoiding incurring new debt or making big purchases. If there is no way to pay off all of your credit card debt, focus on high-interest and store credit cards.
Please keep in mind that this is just general advice. To address your specific situation, you’ll want to contact a lender who can walk you through what you can do to put yourself in the best position to be approved for a home loan with an affordable interest rate.
Sur-Ryl Homes wants to be your partner in making your dreams of homeownership come true. Contact us today to get started.