Why DTI ratio is so important for home buying

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By: tiarajoseph11
on 11th Sep,2015

Learn about DTI ratio before applying for home mortgage and ensure 100% approval.
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If you want to buy a house or want to take a home equity line of credit, then there are several aspects you might need to consider. Taking out a loan is not just about filing some paperwork. Two most important factors can make your approval easier or harder. These are - (a) Debt-to-income ratio (DTI), and (b) Credit score. Among the both factors, the debt-to-income ratio can affect your chances immensely of getting a mortgage loan approved.

1. Debt-to-Income Ratio – What is it?

Most of the monthly gross income of a consumer goes to pay off his monthly debt burden. Debt-to-income ratio (DTI) is a ratio, between your monthly income that you earn every month and the debts which you pay out each month. Its calculation is based on the amount of income and debts, according to monthly figures. The ratio is normally used to judge an individual's affordability. Lenders always calculate the debt-to-income ratio, keeping the gross earning before tax deduction from the salary.

2. Two different types of DTI

There are two DTI ratios which will provide different results.

A. Front-end ratio

B. Back-end ratio

Both types of ratio generate the parentage of a person’s gross income. By this way, lenders can assume the cost which is deducted from the housing expenses. Housing costs may include, monthly mortgage installments, mortgage insurance premiums, etc. If the DTI ratio gets higher anyhow, there are lesser chances for an individual to get approved for any home loan.

Back-end debt-to-income ratio generates the percentage of that gross income which you are spending to pay off the other type of debts. These may include credit card dues, car loans etc. Lenders use this kind of ratio along with the front-end ratio, while giving an approval for a home loan application.

3. Debt-to-Income Ratio calculation

Your DTI will higher if you add more debts in your monthly payments. If your DTI rises, your credit score will also get lower gradually. This may trigger a financial hardship for you. You need to make sure that you are in the right track to maintain a financial status while managing your debts. So, you can use a DTI Ratio calculator to check how much you are saving and contributing towards your monthly debt payments.

4. Debt-to-Income Ratio – What lenders want

Lenders normally prefer the perfect front-end ratio, equal or less than 28%. Also, in case of the back-end ratio, after adding expenses, it must be 36% or lower.

Check out the ratio slabs:

  • 36% or less - The most preferable, lenders will love it because of the healthy debt load. It is quite easier for most borrowers.
  • 37%-42% - Fair, but need to focus on paying down debt loads as soon as possible before getting into hardship.
  • 43%-49% - Bad, you need to take hardcore immediate action to avoid financial difficulties.
  • 50% or more - Worst! You just need to get help from a professional, if you want to survive.

Lenders will decide whether or not you qualify for a home loan after checking your debt-to-income-ratio. The total 28% are inclusive of some payments such as mortgage, fire insurance, homeowner’s association dues, PMI and taxes the for property. Basically, it's called the PITI, derived from Principal, Interest, Taxes, and Insurance.

While considering 36% DTI ratio, lenders normally allow your gross monthly income to include recurrent debts like car loans, credit card bills, child support and several long-term burdens.

It's clearly visible from the above-given criteria that, chances of getting approved for a home mortgage are narrow if you are continuously adding multiple debts. Remember that, apart from your credit history, most of the lenders will surely verify your DTI ratio as the credit score only reveals your payment history. It represents a record on your credibility when it comes to verifying your credits. However, your credit score doesn't have any effect on your income. So, your DTI is considered mostly as a prime aspect to filter your application. Practically, even your credit score is outstanding, you might still be denied by most of the lenders, if your DTI ratio exceeds the red mark, that is, the 36% limit.

Check out how you can increase your credit score.

In the mortgage industry, the 28/36 percentage rule is the most important factor which almost every lender follows. However, after the recent real estate price hike, lenders have become more rigid towards their lending policies.

So, to be on a safer side, you must increase your amount of down payment. By this way, you can avail your home loan at a lower monthly installments. Although, it's quite sure, for getting that much advantage, you should get a 15-year or 30-year mortgage which will take longer years to pay off the entire loan. But, it's safe to acquire the property with a more conventional approach, or else your adjustable mortgage interests can increase your DTI ratio and compel you to file for foreclosure.

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