Most prospective homebuyers understand that their income and credit score combine to have a significant impact on whether or not their mortgage application is approved. They also know that their income and credit score both go a long way toward determining the interest rate on their mortgage. However, what many prospective homebuyers don’t realize is that there is another number that plays just as big a role in the approval process; their debt-to-income ratio. In fact, many mortgage lenders will deny a loan application regardless of income or credit if the applicant’s debt-to-income ratio is above a certain threshold.
What is Your Debt-to-Income Ratio?
Your debt-to-income ratio measures what percentage of your monthly income is taken up by preexisting debt. Examples of the kind of debt most consumers carry include a combination of one or more of the following:
- Car notes
- Credit cards
- Student loans
- Personal loans
- Child support
It is important to understand why this information is so critical to mortgage lenders. By reviewing their lending history, mortgage lenders discovered that borrowers with an excessively high debt-to-income ratio posed a greater risk of default. That’s why a mortgage loan applicant’s history of maintaining a healthy debt-to-income ratio is a key indicator of their ability to pay off a mortgage successfully.
Every mortgage application is processed by a mortgage underwriter. It is the underwriter’s job to analyze the mortgage lender’s level of risk exposure — the likelihood of significant mortgage delinquency or default — in approving an applicant’s loan. Although each mortgage lender sets its own maximum debt-to-income ratio, underwriters likely will deny a loan to an applicant with a ratio that exceeds its maximum threshold.
In cases where mortgage underwriters do approve an application from applicants with a less than ideal debt-to-income ratio, the loan will likely require a higher interest rate and a higher down payment.
How do you Calculate Your Debt-to-Income Ratio?
You can estimate your own debt-to-income ratio pretty easily. Add up the total amount of all your existing monthly debts and divide them by your gross monthly income. For example, if your monthly debts total $1,500 and you make $4,500 per month, your debt-to-income ratio is 33%.
While it’s good to have an idea of your debt-to-income ratio before applying for a mortgage, you should remember every lender has its own formula for calculating it. The lender may or may not include certain debts in its calculation, and because it is the one with the money, its calculation is the one that matters.
What is a Lender’s Preferred Debt-to-Income Ratio?
Just like every mortgage lender has its own method of calculating debt-to-income ratio, they all have their own preferred debt-to-income ratio. As a general rule, the ideal debt ratio is around 35%. However, some lenders will approve loans for applicants with a debt-to-income ratio as high as 43% — albeit with a higher interest rate and down payment.
On the more conservative side, some mortgage lenders won’t approve an application for anyone with a debt-to-income ratio over 23%. Aside from the lender’s individual risk tolerance, the type of loan you are applying for also may have a maximum debt-to-income ratio for approval.
How do you Change This Ratio?
The most obvious answer to this question is to pay your debts down as quickly as possible. This also will increase your credit score, which elevates your chances of getting your application approved with a customer-friendly interest rate. While taking on some debt such as car notes or student loans is unavoidable, it’s important to remember that high-interest debt like that on credit cards can be very difficult to pay down so you should use credit sparingly.
Resist the urge to splurge on expensive dinners and vacations by putting them on your credit card. The fact that something is on sale with easy credit or long term financing doesn’t mean it’s a good deal. The truth is you would be much better served by saving $100 a month for 6 months and buying a new flat screen TV outright than you would be charging it on a credit card and paying it off in a year. That’s because every dollar in debt you take on has a negative effect on your debt-to-income ratio.
The bottom line here is that it’s much harder to get out of debt than it is to get into it, and mortgage lenders are very sensitive to the risk posed by lending to borrowers with a high debt-to-income ratio. If you estimate your own debt-to-income ratio and it’s near the 43% threshold, you may need to put your aspirations of buying a home on hold until after you pay down some of the debt. Either that or prepare to pay a higher down payment and more interest, which could cost you tens of thousands of dollars (or more) over the life of the loan.
Benzinga’s Best Mortgage Lenders
Remember, every lender has its own loan approval formula, so a debt-to-income ratio that may be too high for one may be acceptable for another. Regardless of what your particular debt-to-income ratio is, it’s best to consult with a number of different mortgage lenders if you’re seriously considering purchasing a home. To help you with this, Benzinga has compiled a list of their best mortgage lenders, which will appear below:
- securely through loanDepot Mortgage Refinance's websiteBest For:Comparing LendersRating:
The Bottom Line on Debt-to-Income Ratio
The mortgage loan approval process involves several important considerations. Obviously, the home being mortgaged must appraise for the same or more than the mortgage amount requested. But on the application side, the would-be borrower’s debt-to-income ratio is just as important as the credit score. Applicants with high credit scores can easily have a mortgage loan application denied if the underwriter believes they are carrying too much debt.
All of this underscores the importance of managing your finances and using credit responsibly. If you’ve had a mortgage application denied because of your debt-to-income ratio or you know your debt-to-income ratio is higher than ideal, it’s time to get proactive. Sit down with a credit counselor and make a plan on how to pay down your high-interest debt. The hard work will pay off when you are looking at preapproval letters with low interest rates from multiple lenders!
What is the highest percentage of debt-to-income ratio?
Every mortgage lender has its own ideal debt-to-income ratio. Some lenders are more conservative than others and won’t lend at more than 28%, while others set their maximum threshold at 35%. In order to protect consumers from themselves, the Consumer Financial Protection Bureau or CFPB will not allow even more lenient mortgage lenders to make mortgage loans to borrowers with a debt-to-income ratio that exceeds 43%.
What bills are included in your debt-to-income ratio?
As a general rule, mortgage lenders will include the following bills in your debt-to-income ratio:
- Preexisting mortgages or rent
- Credit card bills
- Car notes
- Personal loans
- Child support
- Student loans
- Property taxes
- Health insurance premiums
- Car insurance premiums
Bear in mind that every lender has its own formula for calculating debt-to-income ratios, which also means there may be some variance in the debts they include in the calculation.
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