There are plenty of factors that go into the approval of a home loan, including your debt-to-income ratio.
While your debt-to-income ratio doesn’t have a direct impact on your credit score, it’s an important part of your overall credit health. It’ll also play a key role in how well your application will fare when you’re trying to obtain a mortgage.
What Exactly is a ‘Debt-to-Income Ratio’?
Lenders are not in the business of handing out large chunks of money to people who may not be able to pay the loan back in full. They have a set of criteria that borrowers need to meet before any money is loaned out. By setting up these requirements, lenders are able to hedge against any potential risks they may face.
In addition to your credit score, financial history, and collateral, lenders will also have a look at your debt-to-income ratio. This little number is basically calculated by dividing your monthly income by all your monthly debt payments. That includes any auto or student loans, credit card loans, and any other types of debt you may have. You’ll need to provide proof of income, since it’s not reported on your credit report.
Your debt-to-income ratio gives lenders the ability to judge how much more debt you’d be comfortable handling, and how much of a risk you might be for the lender. For instance, if your gross monthly income is $4,000, and your monthly debt obligations total $1,500, then your debt-to-income ratio is 37.5% ($1,500 divided into $5,000).
What Should Your Debt-to-Income Ratio Be to Secure a Mortgage?
The lower the number, the better. Ideally, your front-end ratio shouldn’t be any more than 28%. This specific ratio is the percentage of your income that would be dedicated to paying all your home’s expenses, such as your mortgage payments, property taxes, homeowner’s insurance, and HOA fees.
The back-end ratio shows what percentage of your income would cover all of your expenses, including your housing expenses and all other debt obligations you have. Ideally, this number should be less than 36%. It’s the back-end ratio that lenders tend to place the most weight on. Studies have shown that borrowers who have a higher debt-to-income ratio are more likely have problems meeting their monthly mortgage payment demands.
Lenders might accept slightly higher ratios depending on your credit score, down payment, overall amount of savings, and the exact type of loan you’re applying for. But generally speaking, anything over the 36% mark will raise flags for your lender.
Not only does calculating your debt-to-income ratio protect your lender, it also protects you from getting yourself into a potentially challenging financial position. If the money you make just barely covers all your expenses, you’ll essentially be left with nothing at the end of each month. Rather than being “house poor,” you might want to wait until your debts have whittled down somewhat, your income increases, or you’ve found a more affordable property that more closely matches your financial capabilities.
Even if you are approved for a mortgage with a high debt-to-income ratio, you’ll likely be slapped with a higher interest rate. Much like borrowers with low credit scores are offered high rates if they’re approved for a home loan, borrowers with high debt-to-income ratios will often be offered the same.
For lenders, it’s all about making the most on a return on investment. The main reason why they charge borrowers with a high ratio a higher interest rate is to offset the potentially greater default rate.
The Bottom Line
Your debt-to-income ratio is a critical component to the mortgage application approval process. Lenders want to make sure you’re fully capable of covering all of your expenses after adding a mortgage to the pile. The lower that number is, the higher your odds of being approved for a mortgage with a decent interest rate.