Most Americans carry a large amount of debt. In fact, according to USA Today, the average American household owes over $16,000 in credit card debt alone.
For many younger families, the weight of student loan debt can become an even greater burden. Unsecured debts tend to carry much higher interest rates than loans secured by collateral and having these types of loans makes it harder to buy a home.
The amount of debt obligations you have in relation to your income is a major factor in how much of a home mortgage you can qualify for. This is known as your debt-to-income (DTI) ratio. Lenders naturally want to know what percentage of your income you will have to pay out to finance your debts, so they know if you can afford the mortgage you are applying for.
How Debt-to-Income Ratio is Calculated
Lenders calculate your DTI ratio by dividing your monthly debt obligations by your gross (pre-tax) income. In general, there are two DTI ratios lenders look at to assess your ability to afford the mortgage you are applying for:
Front-End DTI Ratio: This is percentage of your monthly income that will be used to pay your housing expenses for your future mortgage. This typically includes mortgage, property taxes, homeowner’s insurance, and homeowner association (HOA) fees (if you have any. Lenders normally like to see a front-end DTI of under 33 percent. For example, if your gross monthly income is $6,000, lenders would want your housing payment to be $1,980 or less.
Back-End DTI Ratio: This is the percentage of your monthly income that is needed to pay your debt obligations such as car payment(s), credit cards, student loans, and personal loans. The back-end DTI ratio is probably the most important figure to the lender, because it accounts for your entire debt load including your new proposed mortgage payment. Most conventional lenders want to see a back-end DTI ratio of 45 percent or under. So using the example of $6,000 in monthly income, your back-end DTI ratio should not exceed $2,700. Government-backed loans (such as FHA loans) may consider a higher back-end DTI ratio, possibly as high as 55 percent.
How to Lower Your Back-End DTI
If your monthly debt obligations are pushing 55 percent or more of your gross monthly income, you will need to do something to lower that percentage before you can qualify for a home loan. There are only two ways to accomplish this:
- Increase your income.
- Lower your monthly debt obligations.
We would all like to have more income, but for many individuals, that is not a realistic option. To raise your income, you either need to get a raise at your current job, be promoted to a higher-paying job within the same organization or find a better-paying job outside the company. You could also look at taking on a second job or starting a side business to grow your income.
If you are not in the position to raise your income, the other approach is to lower your monthly debt. One way to do that is to start paying off your credit cards. You may also want to consider getting a debt consolidation loan. If you have good to excellent credit, you may be able to consolidate your monthly debts into one loan with a lower interest rate and lower monthly payment.
Qualifying for a Home Loan
DTI ratio is a major factor in qualifying for a home mortgage, but it is not the sole factor.
Lenders will also consider your credit score, how much of a down payment you have, job history/stability, and other circumstances.
To find out if you would be able to get approved for a home loan, it is best to speak with a reputable mortgage lender. A qualified expert will be able to tell you if you are ready to buy now, and if not, what actions you should take to become eligible for a home loan in the future.