How do mortgage lenders calculate debt to income ratio

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Meet John, a supermarket manager who is married with three school-age children and takes home a comfortable paycheck. Sure, he has some credit card debts and a couple of car loans, but he never misses a payment and assumes that getting a mortgage for a new home should be a piece of cake.

Then comes the bad news. After visiting several banks with a fat folder of financial documents, John is told he’s above the 43% Rule and his loan application is turned down.

What’s the 43% Rule?

The 43% rule is a ratio of debt-to-income, and a crucial standard for deciding who qualifies for a loan and who doesn’t.

In reviewing loan applications, lenders compute the ratio of a person’s debt relative to income. The standard for qualifying for a home loan is 43 percent for loans through the Federal Housing Authority and VA. Conventional home loans prefer the DTI be closer to 36% to insure you can afford the payments, but the truth is that qualifying standards vary from lender-to=lender.  If monthly debt payments exceed 43 percent of calculated income, the person is unlikely to qualify, even if he or she pays all bills on time. At the urging of lenders, the Consumer Financial Protection Bureau asked Congress in early 2020 to remove the 43% standard as a qualifying factor in mortgage underwriting.

For other types of loans – debt consolidation loans, for example — a ratio needs to fall in a maximum range of 36 to 49 percent. Above that, qualifying for a loan is unlikely.

The debt-to-income ratio surprises many loan applicants who always thought of themselves as good money managers. Whether they want to buy a house, finance a car or consolidate debts, the ratio determines if they’ll be able to find a lender.

What Is a Debt-to-Income Ratio?

Debt-to-income ratio (DTI) is the amount of your total monthly debt payments divided by how much money you make a month. It allows lenders to determine the likelihood that you can afford  to repay a loan.

For instance, if you pay $2,000 a month for a mortgage, $300 a month for an auto loan and $700 a month for your credit card balance, you have a total monthly debt of $3,000.

If your gross monthly income is $7,000, you divide that into the debt ($3,000 /$7,000), and your debt-to-income ratio is 42.8%.

Most lenders would like your debt-to-income ratio to be under 36%. However, you can receive a “qualified” mortgage (one that meets certain borrower and lender standards) with a debt-to-income ratio as high as 43%.

The ratio is best figured on a monthly basis. For example, if your monthly take-home pay is $2,000 and you pay $400 per month in debt payment for loans and credit cards, your debt-to-income ratio is 20 percent ($400 divided by $2,000 = .20).

Put another way, the ratio is a percentage of your income that is pre-promised to debt payments. If your ratio is 40%, that means you have pre-promised 40% of your future income to pay debts.

What Is a Good Debt-to-Income Ratio?

There is not a one-size-fits-all answer when it comes to what constitutes a healthy debt-to-income ratio. Rather, it depends on a multitude of factors, including your lifestyle, goals, income level, job stability, and tolerance for financial risk.

But there are general rules of thumb to follow when determining whether your ratio is good or bad:

• DTI from zero to 35%: Lenders consider this range a reflection of healthy finances and ability to repay debt. Wells Fargo, for instance, classifies a ratio of 35% or lower as representing a “manageable” debt level relative to your income, where you “most likely have money left over for saving or spending after you’ve paid your bills.”
• DTI from 36% to 43%: While you may still be managing your debt adequately, you are at increased risk of coming up short should your financial situation change. To use a health analogy, while your debt level may not rank as obese, you could benefit from some better financial-fitness habits. You still may be able to qualify for most loans, including mortgages, but you have little room for error. For that reason alone, you should look for opportunities to get your debt-to-income ratio in better shape.
• DTI from 44% to 50%: While you may still qualify for smaller loans, you will have a hard time landing a mortgage once your debt-to-income ratio exceeds 43%, though there have been recent efforts to relax that standard. If you’re in this category, now is the time to consider enrolling in a debt management plan or other debt relief program to improve your ratio and increase your credit-worthiness.
• DTI over 50%: This is generally regarded as an unhealthy level of debt for most households and should serve as a red flag to start working on reducing your debt burden ASAP. At this ratio, you will have trouble qualifying for most loans and are at risk of financial crisis should your expenses rise or income drop. If your debt-to-income ratio is over 50%, you’d be well-advised to explore credit counseling and/or consolidating debt payments.

Calculate Your Debt-to-Income Ratio in 4 Easy Steps

So the trick for many would-be-borrowers is a budget before they go shopping for a loan. Lowering a debt-to-income ratio can be the difference between a dream fulfilled and rejection. Calculating your debt-to-income ratio in easy 4 steps:

DTI Formula

1. Add up what you owe, including credit card debt, rent or mortgage payments, car loans, student loans, and anything else that you are expected to make a constant monthly payment on.*
2. Then calculate your income: wages, dividends and freelance income, alimony, etc. **
3. Now, convert each one of those to a monthly figure. If your annual income is $60,000, the monthly total is $5,000. Do the same for debt. If your annual debt total is $30,000, the monthly total is $2,500.
4. Now divide your debt by your income and multiply by 100 to arrive at a percentage representing your debt-to-income ratio. In this example, that would be 30,000 divided by 60,000 = .5 x 100 = 50%.

Monthly Debt Payments That Are Included in the DTI Formula:

• Monthly credit card payments (you can use the minimum payment when calculating your DTI ratio)
• Monthly mortgage payment (including insurance, taxes, HOA payments)
• Monthly car payment
• Monthly student loan payments
• Monthly personal loan payments
• Monthly debt consolidation loan payments

Income Included in Your Monthly Income When Calculating DTI

• Income from wages, salary
• Income from tips, if applicable
• Income from self-employment (make sure it is verifiable via tax return)
• Income from alimony
• Income from child support
• Income from Social Security
• Income from a pension
• Disability income
• Income from investments such as rental properties, stock dividends and bond interest (must be documented on tax returns)

Monthly Payments Not Included in the Debt-to-Income Formula

Many recurring monthly bills should not be included in calculating your debt-to-income ratio because they represent fees for services and not accrued debt. These typically include routine household expenses such as:

• Monthly utilities, including garbage, electricity, gas and water services
• Paid television (cable, satellite, streaming) and internet services
• Car insurance
• Health insurance and other medical bills
• Cell phone services
• Groceries/food or entertainment costs
• Childcare costs

Front End and Back End Ratios

Lenders often divide the information that comprises a debt-to-income ratio into separate categories called front-end ratio and back-end ratio, before making a final decision on whether to extend a mortgage loan.

The front-end ratio only considers debt directly related to a mortgage payment. It is calculated by adding the mortgage payment, homeowner’s insurance, real estate taxes and homeowners association fees (if applicable) and dividing that by the monthly income.

For example: If monthly mortgage payment, insurance, taxes and fees equals $2,000 and monthly income equals $6,000, the front-end ratio would be 30% (2,000 divided by 6,000).

Lenders would like to see the front-end ratio of 28% or less for conventional loans and 31% or less for Federal Housing Association (FHA) loans. The higher the percentage, the more risk the lender is taking, and the more likely a higher-interest rate would be applied, if the loan were granted.

Back-end ratios are the same thing as debt-to-income ratio, meaning they include all debt related to mortgage payment, plus ongoing monthly debts such as credit cards, auto loans, student loans, child support payments, etc.

Why Debt-to-Income Ratio Matters

While there is no law establishing a definitive debt-to-income ratio that requires lenders to make a loan, there are some accepted standards, especially as it regards federal home loans.

For example, if you qualify for a VA loan, Department of Veteran Affairs guidelines suggest a maximum 41% debt-to-income ratio. FHA loans will allow for a ratio of 43%. It is possible to get a VA or FHA loan with a higher ratio, but only when there are compensating factors.

The ratio needed for conventional loans varies, depending on the lending institution. Most banks rely on the 43% figure for debt-to-income, but it could be as high as 50%, depending on factors like income and credit card debt. Larger lenders, with large assets, are more likely to accept consumers with a high income-to-debt ratio, but only if they have a personal relationship with the customer or believe there is enough income to cover all debts.

Remember, evidence shows that the higher the ratio, the more likely the borrower is going to have problems paying.

Is My Debt-to-Income Ratio Too High?

The lower your debt-to-income ratio, the better your financial condition. You’re probably doing OK if your debt-to-income ratio is lower than 36%. Though each situation is different, a ratio of 40% or higher may be a sign of a credit crisis. As your debt payments decrease over time, you will spend less of your take-home pay on interest, freeing up money for other budget priorities, including savings.[CP_CALCULATED_FIELDS id=”6″]

How to Improve Your Debt-to-Income Ratio

The goal is usually 43% or less, and lenders often recommend taking remedial steps if your ratio exceeds 35%.  There are two options to improving your debt-to-income ratio:

1. lower your debt
2. increase your income

Neither one is easy for many people, but there are strategies to consider that might work for you.

Lower your debt payments

For most people, attacking debt is the easier of the two solutions. Start off by making a list of everything you owe. The list should include credit card debts, car loans, mortgage and home-equity loans, homeowners association fees, property taxes and expenses like internet, cable and gym memberships. Add it all up.

Then look at your monthly payments. Are any of them larger than they need to be? How much interest are you paying on the credit cards, for instance? While you may be turned down for a debt consolidation loan because of a high debt-to-income ratio, you can still consolidate debt with a high DTI ratio with nonprofit debt management. With nonprofit debt management, you can consolidate your debt payments with a high debt-to-income ratio because you are not taking out a new loan. You still qualify for lower interest rates, which can lower your monthly debt payments, thus lowering your ratio.

Remember that improving your DTI ratio is based on debt payments, and not debt balances. You can lower your debt payments by finding a debt solution with lower interest rates or a longer payment schedule.Other alternatives worth considering to lower your expenses and pay off debt:

• Cancel your cable subscription or opt for a cheaper plan to reduce your monthly costs. Then look for ways to save money on your cell phone bill. Can you move to a cell-phone plan that uses less data and costs less?
• Put off large purchases until you have more cash. The more cash you can apply to a purchase, the less you must borrow, so open a savings account to help pay for big-ticket items such as cars and vacations.
• If you have student loans, the bane of the Millennial generation, see if you can get a lower required payment. Lenders use your required minimum debt payment to arrive at an income-to-debt ratio, so the lower the required payment, the better your ratio. Generally, nothing prevents you from making larger payments if you have extra cash — that’s not the issue here.
• Refinance loans if it makes sense. Interest rates have fallen dramatically since the Great Recession and remain low. Check with a lender to see if refinancing, which might involve upfront costs, makes financial sense.
• Change your shopping habits. Consider shopping for groceries at big-box retail stores like Walmart or Costco. See if you can repair, rather than replace, tired appliances. Try to keep your old car running for another year or two and avoid the impulse to buy the fashion-forward clothes when the slightly dated ones will do.
• Sell unneeded stuff on eBay or Craig’s List and apply the proceeds to your debt-payment plan.
• Don’t buy on impulse. If anything is sure to undermine your strategy, it’s unnecessary feel-good purchases.

Most important, make a realistic budget designed to lower your debt and stick with it. Once a month, recalculate your debt-to-income ratio and see how fast it falls under 43%.

Increase Your Income

Improving the income side almost always is more difficult because it requires the one thing no one has enough of – time. Finding a night-time or weekend job that produces even a couple of hundred dollars could be the difference maker in getting your debt-to-income ratio below 43%.

Here are some ways to increase your income:

• Ask for a raise at work
• Start a small business
• Advertise your skills on Craigslist: house cleaning, handy man work, babysitting.
• Start driving for Uber or Lyft.
• Flip furniture or other goods: buy at garage sales and flea markets, sell on eBay and Amazon.
• Mow lawns, shovel snow, pick up holiday shifts.
• If you’re a stay-at-home spouse, watch other people’s kids too.
• Offer rides to the airport from your town for a fixed price. Advertise on a community Facebook board.

Finding a combination of the two – part-time job, plus reducing expenses – is the ultimate solution and might even bring your debt-to-income ratio below the 36% level that lenders are anxious to do business with. If working extra hours doesn’t appeal to you, remember – this is just temporary. You can use the income to pay off debt, reducing your ratio and your need to work extra.

Does My Debt-to-Income Ratio Affect My Credit Score?

The good news if you have high debt-to-income ratio is that it has no bearing on your credit score, because credit-rating agencies don’t include your income among their credit scoring factors. The bad news: Maxing out your credit cards will nevertheless damage your score.

Rating agencies do factor your credit utilization rate (i.e. how much of your credit limit that you use) in determining your score, so it’s no surprise that people who carry high debt burdens often have low credit scores. For example, if you have a $10,000 limit on your favorite credit card and your current card balance is $9,000, the resulting credit-utilization ratio of 90% won’t reflect kindly on your credit score.

Lower credit-utilizations rates equal higher credit scores (not to mention better financial health), with a long-held rule of thumb being to keep balances below 30% of your credit limit. That means living within your means and paying off your credit card balance whenever possible.

Why Is Monitoring Your Debt-to-Income Ratio Important?

Calculating your debt-to-income ratio can help you avoid “creeping indebtedness,” or the gradual rising of debt. Impulse buying and routine use of credit cards for small, daily purchases can easily result in unmanageable debt. By monitoring your debt-to-income ratio, you can:

• Make sound decisions about buying on credit and taking out loans.
• See the clear benefits of making more than your minimum credit card payments.
• Avoid major credit problems.

Creditors look at your debt-to-income ratio to determine whether you’re creditworthy. Letting your ratio rise above 40 percent may:

• Jeopardize your ability to make major purchases, such as a car or a home.
• Keep you from getting the lowest available interest rates and best credit terms.
• Cause difficulty getting additional credit in case of emergencies.

Debt-to-income ratios are powerful indicators of creditworthiness and financial condition. Know your ratio and keep it low.

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