The key that most lenders use to qualify homebuyers for financing lies in what is called the debt-to-income ratio. This equation that compares how much money you owe to the money you make affects whether you can qualify for a mortgage.
As a consumer, your debt load is what you owe in obligations like credit card payments, student loans, car loans, installment loans, car loans, personal debts, alimony, or child support. Meanwhile, income is the sum of the money you make from your job, part-time work, alimony, or income-producing assets such as real estate or stocks.
Your debt-to-income (DTI) ratio helps lenders figure out how (or whether) a home purchase can fit into your financial picture. To calculate your DTI ratio, you simply divide your ongoing monthly debt payments by your monthly income. For revolving debt like a credit card, use the minimum monthly payment for this calculation. This might not match what you typically pay each month but the minimum payment is what most lenders use when calculating DTI. For installment debt, which is money you owe in fixed payments for a fixed number of months use the current monthly payment.
Let’s say you are paying $1500 a month for rent and $500 for an auto payment and several revolving accounts and making a gross income (pre-tax) of $7,000 a month. Divide $2,000 by $7,000 and you have a debt to income ratio of 29%. If your total payment for principal, interest, taxes, and insurance are $3000 a month plus your $500 in debt payment, your debt to income ratio increases to 50%.
Lenders use this ratio to assess your ability to pay for a loan. Lenders like this number to be as low as possible. According to the Consumer Financial Protection Bureau (CFPB) evidence from studies of mortgage loans shows that borrowers with a higher debt to income ratio are more likely to run into trouble making their monthly payments and are therefore more of a risk for mortgage lenders.
As a general rule, if you want to qualify for a mortgage, have good credit and are using a Government-backed loan, loans under $649,750, your Debt to Income ratio cannot exceed 50% of your gross monthly income. If you are applying for a loan over $650,000, your Debt to Income ratio on most loans cannot exceed 43% unless you are looking at loans with less desirable interest rates. The reason for these guidelines is that if you default on your mortgage and your lender has to foreclose on your home, your lender may not be able to recoup their full investment. That would be bad for you also, as a borrower, defaulting on your mortgage can destroy your credit score which would make it more difficult for you to qualify for another mortgage and affect your borrowing on other types of credit also.
Try our simple Home Affordability Calculator. It lets you plug in important financials, including your debt, income, and down payment. Once you have that information, you can connect with one of our mortgage lenders that will help you get a home loan.