What is a Debt to Income Ratio?
Aside from possibly credit, debt will have the greatest impact on your ability to obtain a mortgage. Whether we’re considering the payment on the property you are preparing to finance, or from other debt that you had acquired prior to looking into financing a home, both will play a roll. In this article we'll discuss the basics of debt and debt to income ratios.
You can use our handy mortgage calculators to determine your Debt to Income Ratio.
Two Main Types of Debt
Debt can fall into one of two categories, those being installment and revolving.
Installment debt is an account where you make the same payment each month for a set number of payments. At the end of that pre-determined amortization period the debt has been paid down to a zero balance.
Examples of this include car loans and student loans. With regard to student loans, even if you are deferring payment until after you graduate, you may have a projected payment calculated into your ratios.
If you are within 10 payments of paying off any installment debt, you are most likely able to exclude this debt from your ratios. Keep in mind though that if you are planning on paying down debt to just below the 10 month threshold, for the purposes of having the debt excluded from the ratios, lenders are aware of this practice, and will require you to pay off the entire balance.
Revolving debt on the other hand is more open ended. It is often an open line of credit such as a credit card or home equity line of credit, where you are given some limit, then the balance can fluctuate monthly, as you either use it or pay it down.
A revolving account can sit for extended periods with no balance at all on it, or as is often the case, be at the maximum limit for extended periods. Minimum payments are based on the creditor and the balance. Lenders will use the minimum payment amount on the credit report, regardless of what it is on your monthly statement.
If a credit card account is not reporting a minimum monthly payment on the credit report it is common practice to estimate this amount at 3% of the balance.
Debt to Income Ratios (D.T.I.)
There are two types of debt ratios that you need to be concerned with when it comes to financing a home. They are referred to within the industry as front end ratios (or housing ratio) and back end ratios (total debt ratio).
Front end refers to the ratio of your gross (before taxes) income to your housing payment only. Housing payment refers to principal and interest, property taxes, property insurance and mortgage insurance if you have it.
To put this in real numbers, if you earn $4,000 per month gross, and your housing payment is $1,000. Your front end ratio is $1,000 / $4,000 or 25%.
Continuing on with this example, if you have $500 per month in, let’s say a car payment and student loan. Your back end ratio would now be $1,500/$4,000, or 37.5%.
In tying all of this together, the lower your debt rate, and this would be no secret to anyone, the better your chances are of becoming qualified for a mortgage. A good rule of thumb is that you want to keep your back end ratio below 45%.
Some programs will require a certain housing ratio and a certain total debt to income ratio in order to qualify. When you apply for a mortgage, this information will all go into the computer program your mortgage professional uses, called a “LOS” and he or she will be able to determine quite quickly how your application looks, from a DTI standpoint.
Business Related Indebtedness
It is somewhat common for a small business owner to have debt on his or her credit report that is actually the responsibility of the business. You may have personally guaranteed this financing in order to obtain the credit for your business.
This can be a touchy subject for underwriters. While a personal guarantee or a PG, as it is commonly referred to, is ultimately your responsibility if the business can no longer pay the debt, you may be able to exclude this payment from your debt to income ratios.
In this case you would need to meet all the customary requirements for a self employed borrower and simply provide cancelled checks, showing that the company has paid this account for at least the previous 12 months. If you can provide cancelled checks demonstrating that the company has made these payments for at least 24 months, all the better. This will only strengthen the file further.
As always, there are numerous factors that can have an affect on your ability to be approved or declined for a mortgage. When you are declined for having a debt to income ratio that is a bit too high, you should discuss your options with your originator.
Your mortgage professional will always have some valuable advice on what you can do in order to rectify this problem and get that approval we’re all looking for.