Understanding Debt-to-Income Ratio When Buying a Home
When getting a mortgage to buy a new home, banks and lenders look at many things. One of the items they look at is a borrowers debt-to-income ratio. The debt-to-income ratio (DTI) in home buying doesn't solely refer to the purchase price of the home compared to the buyer's monthly income. It's a way for lenders to quickly assess someone's entire financial history in one ratio. See how DTI can affect a home buyer's chances of being approved for a loan, and what buyers can do if they want to be a more competitive candidate.
How It's Calculated
A DTI calculates total debt based on the following expenses:
- Property taxes
- HOA fees
- Student loans
- Alimony/child support
- Credit card bills
- Car loans
After all official debt has been calculated, lenders will then compare that number to the total income of the buyer. Total income takes into account all sources of funds (e.g., monthly wages, real estate earnings, inheritance funds, etc.). DTI does not include the cost of home utilities, health insurance, or cell phone bills, but buyers should perform their own calculations before determining the price bracket for their housing search and their cap for interest rates.
What Lenders Look For
Lenders are ultimately attempting to safeguard themselves against default, so they're hoping to see as low a percentage as possible. The sweet spot is 36% (or lower). A buyer who unexpectedly loses their job may not be able to meet their mortgage payments and student loan obligations in the same month. Lenders aren't allowed to consider DTI when it comes to the terms (e.g., interest rates, etc.) of the loan, but they are allowed to consider it before approving or denying the loan. Whether income is coming from a trust or from a spouse's real estate investment, the ideal candidates will have several lucrative sources of income that they can rely on in case one disappears.
How to Manage a High DTI
DTI is an important number when it comes to loan approval, but it's certainly not the only factor. Lenders look at everything from the buyer's credit score to their overall financial history before making a final decision. In fact, buyers with a DTI of 43% or higher may be able to secure a competitive rate if they understand the rules of lending.
One solution may be to seek out small creditors for a Qualified Mortgage, or to apply for a government-sponsored program (e.g., FHA, USDA, etc.). These mortgages give lenders legal protections in case a home buyer can't repay the loan. Lenders may allow for a DTI of 50% or even more if the buyer meets specific criteria. For example, a USDA loan is typically only available if the buyer wishes to purchase property in a more rural location, but the low rates and forgiving down payment rules may be enough to make the purchase worth it.
How to Improve a DTI
Avoiding new debt and paring down old debt will always be the most direct course to improve a DTI score. Paying debt will not only improve a DTI, but it can also boost a buyer's credit score into a different bracket. A buyer's credit score will have a lot to do with the interest rates a buyer is offered, so this is a smart approach that can improve the chances of getting the loan at the right terms.
When a Sitka new home buyer understands their DTI, they have a better chance of navigating a home purchase without a lot of surprises along the way. Eliminating debt before even applying for the loan can be the way for a buyer to secure the home of their dreams.