The importance of debt-to-income ratio in mortgage lending

Why DTI is considered as an important factor

While applying for a mortgage, your lender might decide that your financial status is not balanced. No matter how much you earn, pay off your bills on time or how good your credit history is...you'll not be eligible for the loan at all. In the industry of mortgage, the balance of your financial status is measured by DTI (Debt -to-income) ratio. DTI signifies the balance between your monthly income and other consolidated debts like monthly outstanding debts, household expenditures etc.

In todays world, people became so concentrate on building up the credit history, they ignores the importance of debt-to-income ratio. But actually, it is one of the most crucial elements of mortgage loan approval criteria. Understanding your DTI is as much important as keep an eye on your credit history. When you'll decide to apply for a mortgage loan, DTI is one of the important factors which you must consider. So, to clearly understand the importance of DTI, you need to understand the types & how it works.

Types and process of DTI ratio

When you'll apply for a home loan, the lender will check two types of DTI before giving the approval, these are:

1) The front-end ratio - It is also named as the housing ratio. It reflects the percentage of your earnings which you will be spending to pay off the monthly home loan payments, housing taxes, homeowner's insurance and other housing expenditures.

The lender will add your total projected housing expenditures and the amount will be divided by your total income (before taxes). The 100th times of that result is considered as your front-end DTI ratio. For example, You earn $4,000 monthly and your total housing cost is - $1,000. Your front end DTI is = 25%.

2) The back-end ratio - It reflects the percentage of your earnings which you will be spending towards paying down the monthly consolidated debt burden. The monthly debts which you might be paying off is typically the credit card bills, utility bills, auto loan installments, student loans (if any), child support etc and any more debts which will be included in credit reports. Your housing payments and monthly mortgage installments are also a part of this calculation.

It is somehow similar to front-end-DTI ratio, but along with the housing expenses it also includes the other outstanding monthly debts and divided by your gross monthly earning.

For example, let's assume your other debts like credit card bill, student loan payments, car insurance etc will consolidated to the sum of $2000 per month. This amount will be added up with your housing expenditures which is $1000. So the total is ($2000 +$1000) = $3000 per month and it will be divided by your gross income $4000.

Recommended DTI percentage according to the lenders

According to the lenders, the perfect DTI ratio should be:

*Front-end ratio - It should not cross the line of 28%.

*Back-end -ratio - It should be at 36% or lower.

Actually in general circumstances, lender will always consider other factors like credit history and score, loan type, amount of the down payment and financial statement before loan approval. If these aspects are preferable for him, he can allow your high DTI also. But normally for conventional loans the lenders might prefer your back-end ratio.

As a matter of fact, in current lending industry, most of the lenders will not accept any loan application which has DTI ratio more than 45%. There is some exceptions where the lender will allow the application with as much as 50% DTI, only if the borrower can show a savings balance to meet his housing expenditures at least for next 6 months or something like paying down the 50% down payment initially.

DTI for FHA loans

FHA or the Federal Housing Administration have some elasticity in the loan policies. If you apply for an FHA mortgage loan, the appropriate DTI ratio would be -

For Front-end ratio it is recommended not more than 31% and for Back-end-ratio it is fixed at 43%. There is some exception here also. By considering the compensating factors the FHA automated approval system can ease up the process significantly. This system can be very helpful for the borrowers as it would accepts Front-end ratio maximum up to 46.99% and Back-end-ratio maximum up to 56.99% approximately.

How to lower your DTI

Till now, it is totally cleared as a opensky that the lower your DTI will be, the better chances for your loan application. This is because it will show that you can afford and manage your mortgage loan properly. The most easiest way to lower your DTI is to pay off your debts properly. If you do not have the sufficient funds to do that, there is no other effective way. However, if your high DTI only restricts you to get the mortgage loan, you can try out to accompany a co-signer. But Your co-signer must also provide sufficient fund proof and a good credit history to get eligible.