Debt to Income Ratio - The 43% Target
Before a first time buyer, or any home buyer sets out to start viewing properties, getting pre-approved is one of the crucial first steps, but examining your debt-to-income ratio is best done before applying for a home loan.
Why is the debt-to-income ratio of 43% such an important percentage and factor?
This ratio speaks to a home buyer’s financial capacity not so much in terms of buying a home but capacity to faithfully pay on the mortgage and not go into default – as much a concern for the lender as it should be for the home buyer.
For purposes of getting pre-approved for a mortgage, your debt-to-income ratio is calculated simply by adding up all your monthly debt payments and then divide the total by your gross monthly income. This is how mortgage lenders measure a home buyer’s ability to successfully manage monthly mortgage payments and responsible servicing of the debt.
An Example of Debt-to-Income Ratio Calculation
Let’s say your annual income is $60,000 or $5,000 monthly and the home you’re interested in is $200,000 and for the sake of simplicity, you’re putting down 3.5% as with an FHA loan at 4% interest rate.
The amount you’re financing would be $193,000, add to that, again for simplicity, PMI (private mortgage insurance for loans with less than 20% down) property tax of $14 per $1,000 borrowed (check your target community’s property tax rate) and interest.
Your total monthly mortgage payment would total $1,229.89.
Now, let’s add $200 for an auto loan, $400 for revolving debt such as credit cards and accounts plus the mortgage of $1229.89. Obviously, there can be a lot more to an individual’s monthly debt than this, but we’re keeping it simple, but this totals $1,829.80.
Divide the monthly debt of $1,829.89 by the gross monthly income of $5,000 and you get a debt-to-income ratio of 36%.
Congratulations, your debt-to-income ratio is well below the general maximum of 43%.
Mortgage loan studies have long evidenced that home loan borrowers with higher debt-to-income ratios are much more likely to run into financial trouble making the monthly mortgage payments and the 43% limit is the highest ratio a borrower can have but still obtain a qualified mortgage.
There are however, some exceptions, a smaller mortgage lender can, after examining your debt-to-income ratio, still offer a qualified mortgage with a higher ratio, but this is the exception. The lender would have to have under $2 billion in assets in the previous year and no more than 500 mortgages issued in that same year.
Larger lenders may still make a mortgage loan if your debt-to-income ratio is more than 43 percent, even if this prevents it from being a Qualified Mortgage. But they will have to make a reasonable, good-faith effort, following the CFPB’s rules, to determine that you have the ability to repay the loan.
Debt-to-Income Ratio, Understanding a Qualified Mortgage
Qualified loans carry less risk for both the lender and the borrower and a category of loans that have different, specific and more stable features that indicate you are more likely to afford the mortgage payments and faithfully pay the debt.
You may want to read about Mortgage Overlays, which I prefer to call “layers of lending security”. Here is a great article from Luke Skar of Inlanta Mortgage on the subject and how it affects your ability to get home financing: What are mortgage overlays - lender guidelines explained
Mortgage lenders are required to make a “good faith” effort to examine your financial capacity in determining whether or not you have the ability to repay the mortgage and known as the “ability-to-repay” rule, which also involved your debt-to-income ratio.
Take a look at the general requirements for obtaining a qualified mortgage.
Harmful home loan features that are not permitted:
- Interest Only Period – This is when a borrower is making interest only payments for a term and not paying down the home loan’s principal and the amount the home buyer borrowed.
- Balloon Payments – A borrower makes a larger, often much larger payments toward the end of the loan term in exchange for smaller payments earlier on.
- Negative Amortization - A predatory lending practice, this allows your loan principal to actually increase over the life of the loan, even though you are making the mortgage payments.
Credit Profile and FICO Score is as Important as Debt-to-Income Ratios.
Before you start seeking out a mortgage lender and pre-approval, you now know to get a handle on your debt-to-income ratio but equally important to securing a pre-approval and qualified mortgage is getting your credit profile and FICO score within accepted mortgage lending range.
Credit profiles and FICO scores will be the next post on our Complete Southwest Ohio Real Estate Blog, stay tuned and check back.
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