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Key Facts About Debt-To-Income Ratio

Key Facts About Debt-To-Income Ratio

By Evelyn Olmedo

The lender asks for your debt-to-income ratio (DTI) in order to determine whether you qualify for your first mortgage loan. You blank out. What is the lender asking you?

The answer:

To calculate your monthly debt divided by your gross monthly income.

DTI measures your ability to pay off your future mortgage loan in addition to the monthly expenses you incur. For example, Sally’s monthly expenses include: $200 for her car loan, a $150 student loan repayment, $60 for her phone bill, $8.99 on Netflix, and $5.99 for Itunes music, this equals $424.98. Now divide $424.98 by $2,400 (monthly gross income), this gives a debt-to-income ratio of 17%. If your DTI is lower than 33% then lenders will consider you a lower risk.

Why is Debt-to-Income Ratio Important?

First time buyers should earn enough money to be able to afford additional debt such as a mortgage loan. Your DTI will help lenders determine what level mortgage you can afford. There are two types of DTI calculations that may be used by a mortgage lender, these are front-end and back-end debt-to-income ratio.

Front-End Ratio: The measurement that represents the ratio of your monthly gross income to monthly mortgage payments. You can calculate this by dividing your monthly housing expenses—such as the mortgage payment, property tax amount, and home insurance premium—by your monthly gross income. Normally, front-end is used for government loans such as VA or FHA mortgages.

Back-End Ratio: Most lenders will check your back-end ratio because it gives a clearer picture of your personal finances including all monthly expenses such as student loans, car loan and credit card debt. Remember Sally, we used back-end ratio to determine how much she can afford for a mortgage loan.

Understanding How Your DTI Affects Your Mortgage Application

Advantages Of A Good Debt-To-Income Ratio:

Mortgage lenders favor a lower DTI because you can easily pay off your loan as opposed to a higher DTI, which forces you to live paycheck to paycheck. DTI helps you understand how much of your income is tied up in monthly expenses so you can make smarter decisions about your personal finances.

Disadvantages Of A Bad Debt to Income Ratio:

You have more debt than you can afford. A mortgage lender will see red flags if a large percentage of your income s tied up in monthly expenses. Borrowers with high DTI are high risk to the lender as it may be difficult for them to make monthly mortgage payments. People with bad DTI will struggle to get a mortgage application approved.

What Are Your Options If You Have A Bad Debt-To-Income Ratio?

Your main options are to improve your personal finances by reducing your debt, increasing your income, or creating a better budget to save money. You could also consider using a cosigner, which may be a friend or family member, to cosign your mortgage loan and help you meet the qualifying requirements. A qualifying cosigner must demonstrate a sturdy income, excellent credit score, and a low DTI. The benefit of using a cosigner is that it gives you the opportunity to buy a home now, without improving your DTI. However, if you need to use a cosigner to get an approved mortgage you should really consider whether you’re in a financially strong enough position to afford a mortgage.

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