Debt-to-Income Ratio –It’s Just as Important as Your Credit Score When Buying a New Home

Your debt-to-income ratio (DTI) is a simple way of calculating how much of your monthly income goes toward debt payments. Lenders use the DTI to determine how much money they can safely loan you toward a home purchase or mortgage refinancing. Everyone knows that their credit score is an important factor in qualifying for a loan. But in reality, the DTI is every bit 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 the mortgage loan, mortgage insurance, fire insurance, property taxes, and homeowner’s association dues. This is usually called PITI, which stands for principal, interest, taxes, and insurance.

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 say your gross earnings are $4,000 per month. $4,000 times 28% equals $1,120. So that is the maximum PITI, or housing expense, that a typical lender will allow for a conventional mortgage loan. In other words, the 28 figure determines how much house you can afford.

Now, $4,000 times 36% is $1,440. This figure represents the TOTAL debt load that the lender will permit. $1,440 minus $1,120 is $320. So if your monthly obligations on recurring debt exceed $320, 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 $320, your PITI must be reduced to $840 or less. That translates to a much smaller loan and a lot less house.

Bear in mind that your car payment has to come out of that difference between 28% and 36%, so in our example, the car payment must be included in the $320. It doesn’t take much these days to reach a $300/month car payment, even for a modest vehicle, so that doesn’t leave a whole lot of room for other types of debt.

The moral of the story here 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 only reflects your payment history. It’s a measurement of how responsibly you’ve managed your use of credit. 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. So even if you have a PERFECT payment history, but the mortgage you’ve applied for would cause you to exceed the 36% limit, you’ll still be turned down for the loan by reputable lenders.

The 28/36 rule for debt-to-income ratio is a benchmark that has worked well in the mortgage industry for years. Unfortunately, with the recent boom in real estate prices, lenders have been forced to get more “creative” in their lending practices. Whenever you hear the term “creative” in connection with loans or financing, just substitute “riskier” and you’ll have the true picture. Naturally, the extra risk is shifted to the consumer, not the lender.

Mortgages used to be pretty simple to understand: You paid a fixed rate of interest for 30 years, or maybe 15 years. As time went on, mortgages started to come in a variety of flavors, such as adjustable-rate, 40-year, interest-only, option-adjustable, or piggyback mortgages, each of which may be structured in a number of ways. Many of these types of loans helped contribute to the mortgage crisis in 2008.

The whole idea behind all these types of mortgages was to shoehorn people into qualifying for loans based on their debt-to-income ratio. “It’s all about the payment,” was the prevailing view in the mortgage industry. That’s fine if your payment is fixed for 30 years. But what happens to your adjustable rate mortgage if interest rates rise? Your monthly payment will go up, and you might quickly exceed the safety limit of the old 28/36 rule.

These alternative mortgage products were fine as long as interest rates didn’t climb too far or too fast, and also as long as real estate prices continued to appreciate at a healthy pace. Make sure you understand the worst-case scenario before taking on one of these complicated 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. As we have gotten further away from the mortgage crisis that helped ruin the economy in the early 2000, lenders are now stretching those ratios based on the strength of the rest of the file.

Make sure you understand exactly how far or how fast your loan payment can increase before accepting a non-traditional type of mortgage. If your DTI disqualifies you for a conventional 30-year fixed rate mortgage, then you should think twice before squeezing yourself into an adjustable rate mortgage just to keep the payment manageable.

Instead, think in terms of increasing your initial down payment on the property in order to lower the amount you’ll need to finance. It may take you longer to get into your dream home by 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.

Consolidate Bills with Cash-out Mortgage Refinancing and Make Your Monthly Payments Fit Your Budget

Have you seen enough commercials about credit card and other types of debt? Do you feel like all these commercials are directly talking directly to you? Have you finally decided it’s time to take advantage of these offers and get your finances under control? If your goal is to consolidate bills and bring your finances back under your control, a refinance of your mortgage that will allow you to do this is exactly what you need.

If you are paying each month on three or four different credit cards at an interest rate of at least fourteen percent, those monthly minimums will certainly add up. Each of those balances are charged the interest rates each month. When you consolidate bills instead of spreading them out, you are being charged interest on only one amount at what can be a fixed and, usually, lower rate than what your credit cards will charge you.

Several mortgage companies, including our own, offer mortgage refinances that are specifically designed to help you pay off your credit cards and consolidate bills by rolling those bills into your mortgage amount. One of the benefits of getting this type of loan is the fact that you will go from several bills each month coming due at different times to one bill due at the same time each month. In this way, you will only have to keep track of one bill each month and this bill will cover your mortgage as well as your debts. The only other monthly bills that you should have coming in will be your utilities.

In combining all of your debts, you are actually saving money each month. As stated earlier, when you consolidate bills in this way, you will be charged interest on one amount rather than several amounts. Since mortgage loans have lower interest rates than credit cards, you are charged less each month, which leaves more money in your pocket each month. This extra money can be used to pay off extra each month toward your balances or any other way you decide.

Consolidating bills in this way is a decision that will make life easier and give you control again of your finances. Your interest rates will be lower as will your monthly payment. You will save money while paying off your bills and keeping your credit score high. And don’t forget, mortgage interest is tax deductible, while credit card interest is not. So you will be getting a bonus from Uncle Sam as well. Ask your accountant or tax professional for further details.