New homebuyers find their vocabularies expanding when they start shopping for a mortgage. You may already be familiar with terms like “APR” and “credit score.” Both of these will come into play when you look for a loan, as will your debt-to-income ratio.
What is Debt-to-Income Ratio?
The easiest way to explain debt-to-income (DTI) ratio is that it’s the percentage of your income that goes to pay off all debt. Debt includes loans that you need to pay off over time, like a car loan or school loan. It also includes credit cards from both stores and major card providers. It also includes other monthly payment obligations such as child support, too. This ratio is usually expressed as a percentage. You can use the debt calculator at BankRate.com to see how close you are to affording a home.
Your DTI is the amount of money per month dedicated to paying debt divided by your monthly gross income, but there are two types of DTI:
Your back-end DTI affects your qualification for all loans.
It’s important to keep an eye on your back-end DTI, because it affects any and all loans you take out. Your back-end DTI is, as explained above, your monthly debt obligation divided by income. Lenders will look at this debt ratio for car loans and credit card limits. It will also play into any lease agreements, if you rent a home. Keep an eye on your back-end DTI and make sure you’re not overspending your income.
Your front-end DTI affects your ability to get a home loan.
The front-end debt-to-income ratio focuses on the total cost of housing compared to your income. It’s similar to your back-end DTI, except that only includes the cost of the home: mortgage, interest, insurance, property taxes, etc. When shopping for a mortgage, the lender will calculate this ratio based on estimates of the monthly amount you will pay. The front-end DTI determines whether or not you can afford the home.
What is a Good Debt-to-Income Ratio?
The type of mortgage you’re considering will determine the threshold for DTI. Some lenders require that you have a lower percentage of debt to income. Others, particularly those working with government-sponsored housing program, will be more lenient. Statistics have shown that those with higher DTI ratios are more likely to default on a home loan. So, the more risk the lender takes, the lower DTI they want to see:
Conventional Loan DTI requirements are stricter.
Because these loans are only backed by the buyer’s down payment (usually 20 percent), the risk is higher. Lenders prefer a front-end debt-to-income ratio at 28 percent or below. They prefer a back-end (overall) DTI at 36 percent or below.
FHA Loans DTI requirements are more lenient.
The DTI for FHA loans is usually more lenient. Because the Federal Housing Authority guarantees these loans, lenders are willing to take more risk. At the time of this writing, FHA DTI limits for back end are 43 percent, with 31 percent for front-end.
USDA Loan DTI requirements are offset by home prices.
The debt-to-income requirements for a USDA-backed loan is front-end 29 percent and back-end 41 percent. This falls somewhere between the requirements for FHA and a conventional loan. However, this is offset by the somewhat lower cost of housing in rural and less-developed area. Generally, you can buy more home for your money in rural areas.
VA Loans DTI requirements are back-end only.
Unlike the others, the VA only looks at back-end debt-to-income ratio, and sets the limit at 41 percent. This means that a veteran with no or little debt may be able to purchase a higher-priced home, even if the front-end DTI is high.
Why Does Your Debt-to-Income Ratio Matter?
Your back-end DTI affects your ability to get credit for a car loan or lease, rent an apartment, or obtain a credit card. If you’re in the market for a home loan, your debt-to-income ratio will definitely affect the type and size of home you can buy.
You may have little debt, but if the cost of your dream home is 40 percent of your income, you may have to keep shopping. It can affect where you can buy, too. Home prices are often affected by location. If your debt-to-income ratio is too high to buy in that neighborhood, you only have a few choices. You’re going to have to reduce your debt, increase your income, increase your down payment, or start shopping elsewhere.
Your debt-to-income ratio can affect whether or not you can buy a home at all. Even if your credit score is excellent, lenders will consider you too much of a risk if you’re already well in debt.
Even though the lenders will be looking at your debt-to-income ratio, don’t rely on it when you start budgeting fro a new home. When calculating how much home you can afford, remember there are other household expenses. Groceries, gas, clothing and other expenses will affect your budget, as well. If you’re stretching the budget too far to buy your dream home, it will impact your quality of life in other ways.
Featured Image: CC0 Creative Commons by StevePB via Pixabay.