How to Understand Debt-to-income Ratios When Buying a Home

Are you preparing to buy a home? Be sure you follow these important first steps.

Two critically important factors in obtaining a mortgage to buy a home are showing the lender you have both the willingness and the ability to repay the loan they give you to purchase your home. Last blog discussed understanding your credit history.

PREQUALIFICATION:

The other first step in buying a home, after you know what your credit score is, is to obtain a pre-qualification letter from your lender which will determine the purchase price you can afford to repay. Your debt-to-income ratio (DTI) will determine how much income you have available to establish your ability to repay your home loan purchase.

DEBT-TO-INCOME RATION (DTI)

The lender will evaluate your DTI (debt-to-income ratio) which is another factor that represents the risk level which also is reflected in your interest rate. A lower your DTI indicates less risk. Your DTI is the best indication a lender has to judge your ability to repay the loan.

Then the lender will obtain your debts from a current credit report to establish the debt-to-income ratio which will be used. They will take your total monthly debt obligations, including the proposed housing purchase and divide those figures by your proposed gross monthly income.

For example if you have $450/month in credit card and installment loans and your proposed housing costs, including principal and interest, taxes, insurance and mortgage insurance is $1300 that would be a total monthly obligation of $1750 (450 + 1300.) Then if your monthly gross income is $4800/month, the DTI would be 39%.

The front end ratio is housing costs of principal and interest, taxes, insurance and mortgage insurance (if any) / gross monthly income. In the case above that would be $1300/$4800 or 27%.

Lenders usually look at both the front end and the overall debt-to-income ratios. For the above situation the ratios would be expressed as 27/39. To calculate your own DTI take your housing costs/your gross monthly income for the front end ratio and then your total debt, including housing costs/ your gross monthly income for the back end ratio.

CHECK LIST

You should bring the following to your lender so they can evaluate your current income figures:

  • Past two years Federal income tax returns, including all schedules
  • Salaried and/or commissioned employees also will need to provide past two years W-2s and past 30 days of pay stubs
  • Self-employed applicants should also have a current year-to-date profit statement

Different loan programs have different ratio requirements. Some Government loan have maximum front end ratios however are typically more lenient on the back end as compared to some conventional programs. The industry used to say it was ideal to have no more than 1/3 of your income go towards your housing costs (front end ratio) and ideally no more than 45% of your income towards all your debts. However, those standard guidelines are usually set aside and the overall risk as determined by automated underwriting programs takes precedent. Its best to schedule an appointment with a loan officer to obtain direction.

Stay tuned for my next blog with will address the opportunity of purchasing investment properties. In the meantime if you’d like to get started today prequalifying to obtain a mortgage to buy a home in Ankeny, Des Moines or Altoona, call me, Dorothy Mathis at Lincoln Savings Bank 515.327.9938. I have a long history of helping potential homeowners successfully prove they have both the ability and the willingness to qualify for a mortgage to purchase their homes.