What is the Debt-to-Income Ratio?
For home buyers, the “debt-to-income ratio” or “DTI ratio”, is one of the most critical parts of the mortgage loan application. DTI is the number one method by which a bank or lender can measure buyer viability and determine their ability to repay a loan. By dividing the home buyer’s monthly liabilities by gross monthly income, a lender will come up with a percentage that serves as a DTI. In other words, how much can that home buyer spend in relation to their salary?
How to calculate a DTI:
Annual gross income—————$120,000
Monthly gross income————–$10,000
Equals a 35% debt-to-income ratio
In this example, the home buyer’s debt-to-income ratio would be 35% ($3,500/$10,000). Simple, right? Except there are two variations you need be aware of, known as the front-end and back-end DTI.
- A front-end DTI is housing-related debt (i.e., mortgage payments, taxes, insurance, and homeowner’s association fees).
- A back-end DTI includes all non-housing-related regular debts and expenses, such as student loan payments, car payments, etc. Owning another property is considered back-end DTI ratio, because it’s not part of the new loan you are applying for.
Lenders will look at both percentages on your loan application, but the back-end DTI is given the most attention.
When helping a potential home buyer evaluate a home, what target DTI should you aim for?
Thanks to current rules from the Consumer Financial Protection Bureau (CFPB), most mortgages have a maximum back-end DTI ratio of 43%.
With that said, you should help buyers search for homes they can afford AND always advise buyers keep their debt-to-income ratio lower than this. Many lenders will only consider a DTI acceptable if it falls below 36 percent. Generally speaking, the classic “rule of thumb” ratios are 28/36, meaning your front-end ratio shouldn’t exceed 28%, and your back-end shouldn’t exceed 36%, with varying exceptions that may include a large down payment, accumulated savings, solid credit history, potential for increased earnings, etc.
Max DTI by Loan Type
For FHA loans: According to the FHA website, “The FHA allows you to use 29% of your income towards housing costs and 41% towards housing expenses and other long-term debt.”
- In some cases, lenders will defer to the AUS (Automated Underwriting System) for guidance, though there are factors that could create a mortgage overlay, for example, if the property is deemed “riskier”. These limits can also be reduced if your credit score is below a certain threshold. For manually underwritten loans, the max debt ratios are 31/43. However, for borrowers who qualify under the FHA’s Energy Efficient Homes (EEH), “stretch ratios” of 33/45 are used.
For VA loans: A VA loan is a guaranteed loan by the U.S. Department of Veterans Affairs. Military homeowners can qualify for the loan if their DTI ratio meets VA and lender standards.
- The acceptable debt-to-income ratio (back-end) for a VA loan is 41%, but there are compensating factors where you can exceed this threshold, for example, if your residual income is 120% of the acceptable limit for your geography.
For USDA loans: For USDA loans, no down payment is required, and the max DTI ratios are set at 29/41—meaning the buyer’s monthly housing costs (mortgage principal and interest, property taxes and insurance) must meet 29% percent of their gross monthly income, and they must also have enough income to pay new housing costs plus all additional monthly debt (41% ratio).
- However, if the loan is approved via the Guaranteed Underwriting System (GUS), these ratios can be exceeded somewhat similar to FHA/VA loans. Compensating factors include a credit score of 660 or higher and at a minimum a credit score of 620 for the co-borrower.
Avoid Debt-to-Income Ratio Problems – Advice for Home Buyers
Other than asking for more money down, what can home buyers do to lower their debt-to-income ratio prior to being accepted for a loan?
- Stick to essentials — Can you separate your wants from your needs? Consider trimming the fat from your expenses.
- Watch your credit — Have a low credit card balance (generally ~10%), and do not open a new line of credit during the loan application, as lenders might see this as a risky decision.
- Consider reduced documentation — Loans such as SIVA (Stated Income, Verified Assets) loans, and No Ratio (no income, verified assets) loans, may be an option for those who increased their gross income recently, have complicated tax schedules, or are self-employed borrowers.
Avoid Debt-to-Income Ratio Problems – Advice for Lenders
By working with the buyer to understand the “affordability” of the mortgage in terms of monthly PITA (principal, interest, taxes, and insurance) as well as HOA and other recurring costs, lenders and real estate agents can better educate homebuyers and help them search for homes that fit within their DTI. Not only do tools such as RatePlug’s mortgage calculator protect the home buyer from overspending, they also help ensure the agent only shows homes the buyer can afford – which protects the lender from wasting time on applications that get denied (learn about RatePlug for corporate lending teams).