Tuesday December 15, 2015
If you’re looking to purchase a home, you’ll likely run into the phrase “debt-to-income ratio” when trying to qualify for a home loan. We know that understanding your debt-to-income ratio can be confusing, so we’re here to help break it down for you.
What is Debt-to-Income Ratio?
A debt-to-income ratio, or DTI ratio, determines if creditors can trust you with a mortgage. The lower your DTI ratio, the more likely you are to qualify for a loan. Creditors calculate your ratio by dividing all the debt payments you must make each month by your gross monthly income. To simplify, if you make $5,000 a month and must pay $1,000 to your creditors, for example, your DTI ratio is 20%.
To determine whether you can afford to take on more debt, many lenders also calculate what your DTI will be if they give you a loan. Say you currently make $5,000 a month and must pay $1,000 in debt payments, but if you get a mortgage, you will have to pay another $1,000 in mortgage payments. The projected DTI ratio for your mortgage will thus be 20%; lenders call this the front-end ratio. Once you combine the front-end ratio with your current liabilities, your total DTI ratio will be 40%; this is known as the back-end ratio. Many lenders will list you as having a 20/40 ratio.
What is a Good Debt-to-Income Ratio?
Under current regulations, creditors cannot give mortgages to borrowers with a DTI ratio of 31/43 or higher. There are, however, a number of exceptions based on:
- Sustainability: If the Federal Housing Administration deems a home to be Energy Efficient, the maximum DTI ratio rises to 33/45.
- Income: Borrowers with very high incomes, or who reasonably expect their incomes to increase in the near future, may borrow with a higher DTI ratio.
- Credit Rating/History: The better your credit history, the more debt you can safely hold.
- Underwriting: If the Army of the United States or the Guaranteed Underwriting System underwrites your loans, you qualify for high DTI ratios from certain lenders.
How to Reduce Your Debt-to-Income Ratio
If you want to apply for a mortgage but your DTI ratio is too high, you can lower it by:
- Boosting Your Income: While this is easier said than done, many employees can raise their compensation simply by learning how to negotiate.
- Making Larger Payments: The more money you devote to debt payments, the more quickly you’ll pay off the principal, lowering your total interest payments. If you have multiple debts, focus on paying off the largest ones or the ones with the highest interest rates first.
- Consolidating: Debt consolidation companies can combine all of your debt financing into a single payment, making it easier to keep track of your debts and pay them off quickly.
- Negotiating With Lenders: Creditors are often willing to forgive a portion of your debt in order to ensure that you pay off the rest of it, so check with your creditors to see if they can help.
Lowering your DTI ratio doesn’t necessarily mean avoiding debt. Rather, it means steering clear of unproductive debts in favor of debts that will boost your income. Student loans, for example, are a worthy form of debt, as education will improve your job prospects. Debt to finance a vacation, on the other hand, is not.
Smith Douglas Homes is committed to helping people throughout the Atlanta area find and afford their dream homes. If you’re ready to begin the process of purchasing a home, contact us today and let us get you started.