Before we get started in this blog post, we wanted to thank Al Rapoport of GMI Home Loans for putting together this outline of helpful mortgage financing tips. Please listen to our interview with Al on NJ Real Estate Today Radio. Please contact Al for follow-up questions: 908-244-8107.
What is a debt to income ratio (“DTI”)?
Banks calculate a DTI for one purpose… to make sure a borrower can afford the mortgage being taken out in addition to their other monthly obligations. A DTI calculation allows an underwriter to determine whether the borrower is stretching beyond their means or not. Remember, the last thing that banks want to do is give the borrower a loan that they can’t afford.
Income vs. Assets
In order to understand how a DTI is calculated, one must first know what income is. The simplest way to distinguish between income and an asset (which is not factored into a DTI calculation) is to determine whether the money is received regularly or as a one shot deal. Money that is received regularly (weekly, bi-weekly, monthly, etc.) is generally considered income. Income can come from a job, child support, alimony, foster care, various types of military pay, pension, social security, rent, trust income as well as some others. Generally speaking, an underwriter will need to document both a history of receiving this income and a probability that it will continue.
What is an asset?
Some of the more common assets are savings account, checking account, stocks, bonds, retirement plans, CDs, vested interest in a life insurance policy as well as others.
How is a DTI calculated?
To calculate a debt to income ratio, one must tally up the total of the gross monthly income. Remember, non-taxable income (such as social security) may be grossed up by
125% per Fannie Mae Guidelines. On the other hand, only a percentage of the rental income may be used and this will vary from 75% to 85% depending on the
loan program. Because a DTI calculation looks at what you earn versus what you spend on a monthly basis, the sum of all monthly expenses (such as other mortgages, car payments, business debt signed for personally, co-signed loans, student loans, credit card payments, installment/bank loans, child support, alimony among some others) must also be figured out.
Then, the total debt is divided by the total income to come up with a debt to income ratio. For example a borrower with a monthly income of $5,000 and total monthly debt of $2,000 would have a 40% DTI ratio.
What are the implications of a high DTI?
Too high of a DTI means that you may be buying more home than you can afford and consequently may cause your loan to be denied.
The maximum acceptable DTI will completely depend on the loan program being applied for as well as the lender that you are applying with. It is true that secondary market players will set the maximum DTI thresholds that they are willing to purchase on the secondary market. However, many lenders will then impose even stricter guideline overlays to ensure better loan quality.
Generally speaking, the ideal DTI ratio for an FHA loan is 31/43 or less. This means that the total housing payment accounts for no more than 31% of gross monthly income. It also means that the total overall payment (including the housing payment and other debts) accounts for no more than 43% of gross monthly income. Of course, with
certain compensating factors, there are exceptions to this guideline. In certain cases, borrowers may be allowed to spend up to 50% to 55% of their gross monthly income if they have compensating factors such as strong credit, job stability, good assets, etc.
For conventional financing, the maximum DTI allowed varies depending on one’s down payment. With a down payment of less than 20%, the maximum DTI threshold will be set by the private mortgage insurance (PMI) companies and will be based on a combination of down payment percentage and credit score. Most PMI companies cap the total DTI at either 41% or 45% depending on the borrower’s credit and down payment.
What can I do to lower my DTI?
There are actually several ways to help lower a debt to income ratio. A common approach is to add a co-signer to the loan. Remember that a cosigner brings to the table both debt and income so the ideal co-signer will have a low debt-to-income ratio. A borrower may also consider putting more money down to help reduce the monthly payment.
Another option may be to buy down the interest rate to lower the monthly payment. The recoup time should be considered in this case to make sure that it makes sense to buy down the rate.
Quick Tip #1
– Debt paid for by another person or entity is generally not counted into the DTI calculation. For example, let’s say Joe is buying a house but co-signed for a family member’s car. If it can be documented that the family member has been the sole payer of that car on time for the past 12 months (although a shorter time may be allowed on a case by case basis), then that payment would not be counted into Joe’s DTI calculation.
This can also be a very useful tip for self-employed people who pay for cars or other debt through the business. If the business can document 12 timely payments, then the debt is not counted against the individual.
Quick Tip #2
– Installment loans that are being paid off or paid down to 10 or fewer remaining monthly payments should generally not be included in the borrower’s long-term
Quick Tip #3
– If a revolving account is to be paid off and closed, a monthly payment on the current outstanding balance does not
need to be included in the borrower’s debt-to-income ratio.
Powered by Facebook Comments