Buying a home is a big step. It can also be a long and tedious one. The home loan process requires conquering a multitude of hurdles. However, the end result is well worth the effort. To acquire your dream home, your mortgage lender will look at a wide range of factors. One such component examined is your debt to income ratio, or DTI. In short, your DTI is the percentage of your monthly gross income that is used to pay your debts. Learn more about debt to income ratio and what it means for homebuyers.
Debt to Income Ratio Explained
To determine your debt to income ratio, your lender will divide your combined monthly debt payments by your monthly gross income. A person’s gross income is typically the amount of money that you have earned before taxes or deductions are taken out. Using this number, a lender is able to properly measure your ability to manage a new debt payment, such as a mortgage.
Example: If you pay $1,200 a month for your mortgage, $200 a month for a car loan, and $300 a month for your remaining debt, your monthly debt payments are $1,700. If your gross monthly income is $5,000, then your debt to income ratio is 34 percent.
Having a high debt to income ratio is often frowned upon by home loan lenders. If your debt to income ratio is believed to be too high, it is very likely that you will be denied for a mortgage by a Fairfax mortgage broker. While every lender is different, most lenders will not qualify you for a mortgage if your debt to income ratio is higher than the standard 43 percent. Borrowers with a DTI higher than 43 percent are believed to be too risky.
Factors Considered When Calculating Debt to Income Ratio
Your debt to income ratio plays an important role in home loan eligibility. Your lender will want to determine how much of your income goes towards various debt responsibilities, such as credit cards, auto loans, mortgage payments, rent, and credit lines. However, certain monthly payments are not included in your debt to income ratio, such as the cost of electricity, gas, cable, or groceries.
When a Fairfax mortgage broker sees that your debt to income ratio is high, it means that your finances are tight and that makes you a risky borrower. However, if your DTI is low, a lender sees that you have extra money in your budget to take on unexpected expenses while still being able to make your mortgage payment. However, there is no exactly number that you must meet to be eligible for a home loan. Some mortgages, such as those backed by Fannie or the US Federal Housing Administration (FHA) allow for higher DTIs under certain circumstances. Calculating your DTI ratio ahead of time can give you some insight about your finances and your ability to borrow.
Effect of Debt to Income Ratio on Your Credit Score
Your debt to income ratio is not only a major factor within itself, but also has a direct effect on your credit score. Your credit utilization rate, the amount of available credit you are using, makes up 30 percent of your credit score. For example, if your credit card with an $8,000 limit and you have a balance of $3,000, your credit utilization is 37.5 percent. To prevent your credit utilization from affecting your credit score, you should aim to lower your utilization rate to under 30 percent. The lower your utilization rate, the better your credit score.
Importance of Having a Low Debt to Income Ratio
There are many perks that come with having a low debt to income ratio, especially when trying to acquire a mortgage. When a Fairfax mortgage broker knows you have ample cash flow after paying your monthly debt obligations, you are in a much better position to not only acquire a home loan but to also a get a loan with favorable terms. A lower DTI ratio often means a higher credit score, which can help you get a lower interest rate on your loan.
How to Effectively Lower Your Debt to Income Ratio
If your debt to income ratio is high, you will want to take the necessary steps to reduce it. Start by increasing the amount you pay each month towards your debt. By applying extra payments, you can lower your debt more quickly. During this time, avoid taking on more debt and postpone applying for any loans. Once you have paid down your debts, it may take one or more months for your credit report to update and show these changes. Be patient and allow your credit score and report to increase before applying for a home loan.
If you have cut your spending and are still struggling to pay down your debt, there are other strategies you may want to consider to lower your debt to income ratio. If possible, try to increase your salary. This may mean asking your employer for a raise or possibly even taking on a side job to raise extra money. Consolidating your debt is also an effective way to reduce your monthly payment amounts. Instead of paying several credit card payments each month, you can consolidate and pay just one monthly payment at a lower rate.
Contact a Professional Mortgage Broker
Your debt to income ratio directly impacts your ability to borrow funds towards the purchase of a home. The lower your DTI, the more appealing you are to lenders. However, not all potential homebuyers have the “ideal” debt to income ratio. This is where a Fairfax mortgage broker can help. Whether you have a low DTI and want to know your options or have a high DTI and need help securing a mortgage, an experienced mortgage broker can help. For more information about debt to income ratio or to begin the necessary steps to secure a home loan, contact Fairfax Mortgage Brokers.