A buddy of mine is attempting to buy his first home, and learned a very valuable lesson that no one learns about until they attempt to buy their first house. It is a lesson that most people do not think until their mortgage broker tells them the bad news. I bet you are thinking, “Ugh another Credit Score Post.” Yes, your credit score counts, but you know what else counts Your Debt to Income Ration also referred to as DTI.
What is Debt to Income Ratio?
Investopedia defines Debt to Income Ratio as,
a personal finance measure that compares the amount of money that you earn to the amount of money that you owe to your creditors
The reason mortgage companies care about DTI is simple, if your gross income is being used up to pay back old debts (plus your new home expenses) there is a higher chance you are going to default. It is a pretty reasonable assumption, if 40% of my income is being use to pay back school loans and credit cards, and then I double my expenses (so we are up to 80%) isn’t it likely some debt will suffer? Odds say yes, and thus, the mortgage company isn’t going to want to give you the chance.
Calculating Debt to Income Ratio?
The FHA gives us the calculation, we are going to add up:
- The total mortgage payment (principal and interest, escrow deposits for taxes, hazard insurance, mortgage insurance premium, homeowners’ dues, etc.)
- All recurring monthly revolving
- Installment debt (car loans, personal loans, student loans, credit cards, etc.). T
Then, take that amount and divide it by the gross monthly income. Why do they take the gross number? I have no idea, but it benefits us buyers so RUN with it.
What is a Good Debt to Income Ratio?
According to Investopedia, lenders prefer a Debt to Income ratio of less than 36%, with 37% to 40% in that gray-dangerous area, and then 41% to 50% as a danger zone that some lenders will go into. Interestingly, the FHA provides 41% as the Cut off Limit for Debt to Income Ratio.
Regardless of where you fall within these limits, it may be necessary to make some shifts in your life in an effort to qualify for a mortgage
How do I lower my Debt to Income Ratio?
If the point is to lower your monthly payments, you will need to create an excel spreadsheet, sorting your payments from low to high. Then you have to start getting creative:
- Transfer Balances to a credit card company that has a lower minimum payment calculation;
- Get a loan from your 401(k) to pay off higher minimum payment debt;
- Obtain a loan from your Cash Value Life Insurance Policy to pay off higher minimum payment debt; or
- Make more money!
Disclaimer: I am not a mortgage broker or debt counselor. I have bought only one house in my life, so check with a professional before making any moves.