How Debt-to-Income Ratio Affects Mortgages

When it comes to the steps involved in purchasing a home, the most important (and first!) one you should take is getting approved for a mortgage. There are several factors your mortgage lender will consider when determining how much house you can afford, one being your debt-to-income ratio. Here's what you should know when deciding how your debt can impact your ability to take out a mortgage on a home. 

What is a Debt-to-Income Ratio? 

Your lender will do a simple calculation, considering your monthly debts and your monthly income sources, which will show your debt percentage. This ratio paints a picture of your financial strength and prevents you from purchasing a home you may not be able to afford. 

What factors go into your debt-to-income ratio? Essentially, the lower your debt and the higher your income, the more you'll be approved for. In most cases, a lender will want your total debt-to-income ratio to be 43% or less, so it's vital to ensure you meet this criterion to qualify for a mortgage. There's also a housing ratio that lenders look at, which is lower than the total DTI ratio. The housing ratio is the new proposed payment, taxes, insurance, HOA, etc., versus gross income. As a rule of thumb, lenders want it to be around 31% or less. 

Buyer Beware...Of How Much You Can “Afford” 

Because lenders calculate debt-to-income ratios using gross income, which is the pre-tax amount, it's a good idea to be conservative when deciding how large of a mortgage you feel comfortable taking on. You may qualify for a $300,000 mortgage, but that amount may mean living paycheck-to-paycheck rather than being able to save some of your income each month. Also remember, if you're in a higher income bracket, the percentage of your net income that goes to taxes may be higher. 

Self-Employment Affects Your Ratio 

Self-employment is typically sought-after for its flexibility and ability to work from wherever you choose. In most cases, a Form 1099 may come into play if you've done independent work (like a freelancer). You use the 1099s to report gross earnings, then factor in any deductions, expenses, write-offs, etc. to calculate your profit or loss. The profit or loss is what the lender looks at, and the 1099s are the supporting documentation that's needed.  

• You must have the previous two years of income documentation to qualify for a loan. 

• You'll also need consistency within your business, as severe declines or changes from the prior year in income could prove challenging when qualifying for a mortgage. 

Student Loan Debt Matters   

For the millennial generation, saddled with student loan debt and more than half unsure how long it will take to become debt-free, obtaining a mortgage can be trickier. This is because your student loan debt is factored into your debt-to-income ratio. For example, home loans insured by the Federal Housing Administration require your student loan debt to be factored in one of two ways: Your lender must use: 

• Your anticipated monthly student loan payment (must be documented and fully repay the balance), or 

• The greater of one percent of your outstanding student debt balance can be used if you don't know your anticipated monthly payment, or the monthly fee as reported on the credit report 

Even if your loans are deferred, they will be counted as part of your debt-to-income ratio. So, as you can see, your student loans can significantly impact your ability to borrow money to purchase a home. Each program varies, so don't forget to check with your lender about student loan guidelines. 

Don’t Max Out Credit Cards 

Researchers found that more than 38% of American households carry at least some credit card debt. If you're one of these individuals, you should be aware of its implications for your debt-to-income ratio. Your credit card monthly minimum payments are factored into your debt-to-income ratio, so keeping your balances low will be critical when applying for a mortgage. Not to mention, your creditworthiness is part of the mortgage application process, so making your monthly payments on time and limiting the number of credit inquiries in your name to maintain a healthy credit score is essential. 

Improving Your Debt-to-Income Ratio  

If you're considering purchasing a home, it's a good idea to calculate your debt-to-income ratio as part of the planning process. This will help you determine if you have the 43% or less debt-to-income ratio most lenders require. If you find your debt too high, start tackling some of those balances or finding additional income sources to have the best chance of qualifying for a mortgage. Here are a few ways to get started:  

• Use credit cards sparingly. The only way to lower your monthly debts is to pay down your debt, so if you continue to use your credit cards and carry a balance, you won't be able to decrease your monthly expenditure. 

• Keep accurate records of your self-employment income. While you may have at least two years of self-employment under your belt, it can be hard to obtain a mortgage if you don't have the necessary tax records to back up your income earned. 

• Avoid taking out other loans. If you know purchasing a home is on the horizon, carefully consider how you spend your money. It may not be the best time to buy a new car or take out a loan for a new diamond ring, as these will be factored into your debt-to-income ratio. 

• Open a savings account. Start saving now, and those dollars will begin adding up! Putting a sizable down payment on a home will reduce the amount you need to borrow, which means a smaller mortgage payment and a lower debt-to-income ratio. 

While the mortgage process can be complicated, understanding the different requirements can help you prepare for a greater chance of being approved for a new home. Contact our team today if you're ready to take a step toward homeownership.