Why Do Lenders Check Your Debt-To-Income Ratio?

Debt-to-income ratio

Your debt-to-income ratio (DTI) is a simple way of calculating how much of your monthly income goes toward debt payments. The DTI will reveal if your debt is out of proportion with your income. Maintaining a manageable debt level is essential to good financial health.

If you have applied for a mortgage, you most likely know about this calculation. Your debt-to-income ratio is how lenders determine your ability to make monthly payments on the money you plan to borrow.

Lenders use the DTI to determine how much money they can safely loan you toward a home purchase or mortgage refinancing without significant risk. Of course, everyone knows that their credit score is essential in qualifying for a loan. But in reality, the DTI is equally as important as the credit score.

Lenders usually apply a standard called the “28/36 rule” to your debt-to-income ratio to determine whether you’re loan-worthy. 

The first number, 28, is the maximum percentage of your gross monthly income that the lender will allow for housing expenses. The total includes payments on mortgage principal, interest, property taxes, and homeowner’s insurance. This is usually called PITI, which stands for principal, interest, taxes, and insurance. The lender may want to include additional cost like homeowner association dues into that number as well.

The second number, 36, refers to the maximum percentage of your gross monthly income the lender will allow for housing expenses PLUS recurring debt. When they calculate your recurring debt, they will include credit card payments, child support, car loans, and other obligations that are not short-term.

Let’s look at how to calculate your debt-to-income ratio.

Your monthly gross earnings $6,000

28% $1,680 maximum monthly mortgage payment*

*Your maximum monthly mortgage payment includes principal, interest, taxes, and insurance (PITI). This number is what a typical lender will allow for a conventional mortgage loan monthly payment. In other words, the 28 figure determines how much house you can afford.

Your monthly gross earnings $6,000

36% $2,160 total allowable monthly debt*

*This figure represents the TOTAL debt load that the lender will permit. 

Total allowable monthly debt $2,160

Less maximum monthly mortgage payment $1,680

Allowable additional recurring monthly debt $   480

If your monthly obligations on recurring debt exceed $480, the size of the mortgage you’ll qualify for will decrease proportionally. If you are paying $600 per month on recurring debt, for example, instead of $480, the lender must reduce your monthly mortgage payment by $120 to $1,560 or less. The difference means a lower mortgage amount and a smaller home.

Remember, if you have a car payment, it has to come out of that difference. So in our example, your car payment is included in the $480. However, with the recent escalation in the cost of cars, it isn’t unusual these days to reach a $500+/month car payment, even for a modest vehicle, so that doesn’t leave much room for other types of debt.

Some lenders will consider the maximum percentage over 36%. But the desired maximum is not to exceed 36%. Each lender determines its guidelines. 43% is the highest a borrower can have and still qualify for a loan.

The bottom line is that too much debt can ruin your chances of qualifying for a home mortgage. 

Remember, the debt-to-income ratio is something that lenders look at separately from your credit history. That’s because your credit score reflects your payment history. It’s a measurement of how responsibly you’ve managed your use of credit. Your credit score also reflects your debt-to-credit ratio or credit utilization. Credit utilization reflects how much credit you have used versus how much credit is available to you. But your credit score does not take into account your level of income. That’s why the DTI is treated separately as a critical filter on loan applications. This Equifax article explains the differences between debt-to-income and debt-to-credit ratios.

Even if you have a PERFECT payment history, but the mortgage you’ve applied for would cause you to exceed the 36% limit, you may still not qualify for the loan by reputable lenders.

The 28/36 rule for the debt-to-income ratio is a benchmark that has worked well in the mortgage industry for years. Of course, mortgage products may change as the lending market shifts, but a satisfactory credit score and the acceptable debt-to-income ratio have not changed. As a result, you may be able to qualify for a loan above these limits, but it may cost you more in interest or downpayment.

But make sure you understand the worst-case scenario before taking on one of these non-conforming loans. The 28/36 rule for debt-to-income has been around so long simply because it works to keep people out of risky loans.

Mortgages used to be pretty simple to understand. 

You paid a fixed interest rate for 30 years, or maybe 15 years. Today there are many mortgage programs, such as adjustable-rate, 40-year, interest-only, option-adjustable, or piggyback mortgages, each of which may be structured in various ways.

If your DTI disqualifies you for a conventional 30-year fixed rate mortgage, you should think twice before squeezing yourself into another type of mortgage just to keep the payment manageable. Be sure you understand the loan terms thoroughly before signing the closing paperwork.

Instead, consider increasing your initial down payment on the property to lower the amount you’ll need to finance. It may take you longer to get into your dream home using this more conservative approach, but that’s certainly better than losing that dream home to foreclosure because increasing monthly payments have driven your debt-to-income ratio sky-high.

You can also work on decreasing your debt to income-ratio. 

Ways to reduce your debt-to-income ratio are:

  1. Pay down your debt.
  2. Increase your income.
  3. Don’t incur additional debt.

Whether you are considering purchasing a home or not, keeping an eye on your debt-to-income ratio makes good financial sense. It is easy to get over your head when other lines of credit are more easily accessible.

It is also important to remember that you will have additional costs involved with home ownership, not just principal, interest, taxes, and insurance. You can read more about the other expenses involved in home ownership in this previous blog post

Planning for a home purchase is an exciting time. Learning all you can about the home buying process is essential whether you are a first-time or experienced homebuyer.

You can improve your financial life by understanding and monitoring your debt-to-income ratio. Whether you are buying a house, a car, or consolidating debt, this simple calculation will help your stay on track.

Contact me, Charles D’Alessandro, your Brooklyn Real Estate Agent with Fillmore Real Estate, if you are considering buying or selling a home. As a Brooklyn real estate agent with over 30 years of experience, I understand the real estate process and can help you reach your homeownership goals. Reach me by phone at (718) 253-9500 ext. 1901 or by email at [email protected]

Charles D'Allesandro

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