NewBuyer Weblog

Debt-to-Income Ratio: An Important Piece to the Mortgage Affordability Puzzle

Posted by Elizabeth Dennis on January 12, 2010 | No Comments

By now, you’ve heard all about how your credit rating and score will affect your ability to get a mortgage with desirable terms and the lowest possible interest rate.  There exists however, another important piece to the puzzle, and that is your current debt load.  It is one thing to know that you’ve paid your past debts one time; but can you continue to do so if you take this new mortgage?  Calculating what is called your debt-to-income ratio can give you (and your lender) an idea.

What is a Debt-to-Income Ratio?

A debt-to-income ratio represents a percentage of your income that goes toward paying debts.  Think of it as a snapshot of your spending habits.  Calculating your debt-to-income ratio is very easy.  Take a look:

• Monthly Income =  $4,000
• Monthly Debt = $1,000
• Divide $1,000 by $4,000 to get .25
• Your debt-to-income ratio = 25%

What is Included in your Income Number

Let us look in a bit more detail, how we calculated the monthly income number in the above example.

Your debt-to-income ratio is best figured on a monthly basis.  Your biggest source of income will most likely be your salary.  Debt-to-income ratios are based on gross income (that is before taxes and insurance are taken out of your paycheck). To quickly calculate your monthly gross salary, do so with one of two calculations:

• Take your yearly income and divide by 12
• If you get paid biweekly (every other week), take one pay check’s gross pay and multiply it by 2.17

In addition to your monthly paycheck, include:

• Regular income from alimony and child support
• Averages of bonuses, commissions and tips
• Dividends and interest earnings
• Government benefits and assistance
• Income from a side business
• Other miscellaneous income

What is Included in Your Debt Number

Let us take a look at what is included in your monthly debt number:

• Rent or mortgage payment (including property taxes, insurance, private mortgage insurance and association fees)
• Car payment
• Minimum credit card payments (only minimum due; not balances)
• Student loan payment
• Child support and alimony
• Legal judgments
• Other monthly debt obligations

What is Not Included in Your Debt Numbers

• Food bills
• Entertainment expenses
• Utilities
• Clothing
• Informal personal loans

The Results – How to Interpret Your Number

Once you have calculated your debt-to-income ratio, refer to the following to view that snapshot of your spending habits and financial stability:

• 35% or less: a healthy debt load to carry for most people
• 36% – 42%: pay closer attention to your debt before problems arise
• 43% – 49%: take immediate action as financial difficulties may be imminent
• 50% or more: get professional help to aggressively reduce debt

How Mortgage Lenders Use Debt-to-Income Ratios

Mortgage lenders approach the debt-to-income calculation from the other direction.  They strive to offer loans that will keep their customers within a specified debt-to-income ratio range.  Your lender will use two different ratios to analyze your situation; one factors in only your new housing expense and the other uses your existing recurring debt plus your new housing expense.

The first type of ratio is what is known as a front-end ratio.  This is the percentage allowed for housing expenses only.  For conventional loans (we’ll see the limits for other loan types later) the front-end ratio limit is 28%.

From our example above:

• Your monthly income is $4,000
• $4,000 times 28% = $1,120
• The maximum loan the lender should offer is one that converts to $1,120 per month in HOUSING ONLY debt.

So far, your lender has calculated a mortgage payment based on your income and housing debt.  He will now turn his focus toward your other recurring debt.  This can be a game changer.  Your lender wants to make sure you can pay for your new loan and still pay for everything else.  He will calculate what is called your back-end ratio. The back-end ratio is a percentage allowed for housing expense plus your other recurring debt.  In our conventional loan example, a back-end ratio limit is 36%.

• Your monthly income is $4,000
• $4,000 times 36% = $1,440
• The maximum loan the lender should offer is one that converts to $1,440 per month in TOTAL debt.
• If the difference between the back-end and front-end amounts ($1,440 – $1,120) does not cover your other debts, the lender will need to lower the amount he can offer you.

Ratio Limits by Mortgage Type

The front-end and back-end ratio limits differ depending upon the mortgage type.  Conventional loans are defined as any loan that is not backed by the federal government.

• Conventional loans:  front-end ratio of 28 and back-end ratio of 36
• FHA loans: 31 and 43
• VA loans:: 41 and 41
• Jumbo, non-conforming loans: 45 and 55

The Way the Ratios are Written (and are Mistakenly Read)

In this article I have written the ratios as “28 and 36”.  You will see however, the ratio is more commonly expressed as 28/36.  This can be misleading.  These numbers represent the front-end ratio and a back-end ratio.  We are not looking at a fraction or dividing one number into the other. Though because we are talking about ratios, that could be anybody’s first impression.

Other Tips

• Try running your numbers based on net income (after taxes and insurance) to get a better picture of your situation
• Include all of your monthly expenses in your calculation (remember, the lender will only include formal, recurring debt)
• Run your own ratio before you meet with your lender.  Read our article about being a responsible home buyer to see why.

Are You a Responsible First Time Home Buyer?

Posted by Elizabeth Dennis on January 7, 2010 | No Comments

The number one reason for home foreclosures in the United States is a simple one: home owners took out mortgages that they simply could not afford.  It is true that in many cases, the lenders did not do much to prevent these doomed-to-fail loans, and in many instances encouraged them.  Ultimately however, it is the responsibility of the home buyer to know if they can afford a loan that is offered to them.  That said; let us take a look at how critical it is to respect how much you can actually, truly, honestly afford.

How Much You Can Borrow is Different from How Much You Can Afford

A mortgage lender will use a standard calculation to determine how much he is willing to lend you.  He will gather from your application, information about your income, debts, credit, and available down payment.  By calculating what is called a debt-to-income ratio, your lender will determine how much he can safely (an extremely subjective term) lend you.

However, you must know the following about the lender’s calculation:

• Only recurring debt is included, such as home equity loans, car payments, minimum credit card payments, student loans, furniture store loans, alimony, child support, etc.
• Other miscellaneous debts and obligations such as informal personal loans are not included
• Other household and living expenses are not considered
• Expenses associated with your personal life style are not considered
• Future financial demands and plans with regards to career and family are not considered
• The ratio is based on your gross income, not after-tax income

As you can see, with the many debts and obligations that are excluded in the lender’s calculation, the amount of money he can offer will most likely be higher than you would have thought it to be.  This is where the trouble begins for many home buyers.

Awaken the Responsible Home Buyer Within

By the nature of the many debts and obligations excluded from the debt-to-income ratio;  it should be obvious that the lender’s number simply isn’t going to work for you.  This is where personal responsibility comes into play.  Do not ignore the discrepancy between the lender’s numbers and what you can truly afford.  And don’t be discouraged.  This is your reality; embrace it and adjust.  Look a little harder for a suitable home that fits your budget or perhaps rent until you remove other debts or save for a larger down payment.  Do whatever it takes to avoid becoming house poor or worse yet, foreclosing on your new home.

When to Do Your Own Calculations

You can see the importance of running your own numbers before you talk with a lender.  Walk into a lender’s office telling them what you can afford and what you are comfortable paying.  It is so easy to become “wowed” by your overinflated buying power.  As they say “don’t even go there!”

Mortgage Pre-Approval is Worth More than Being Pre-Qualified

Posted by Elizabeth Dennis on January 4, 2010 | No Comments

The words look and sound the same, but being pre-qualified and pre-approved for a home loan are different things.  Let us take a look at their differences and how they compare to a full loan approval.

Pre-Qualified

The process of getting pre-qualified for a home loan is quite easy.  You can do so in person at a local bank or mortgage lender or better yet, on the phone or via the internet.  The service is usually free of charge.  The lender will ask you for very basic personal and financial information.  Be prepared to provide your:

• address and how long you have lived there
• total income
• total debts
• current assets
• overview of your credit standing

The lender will use this information to estimate what you will likely be able to borrow.  This is an “educated guess” and is simply used to ballpark the price range for your new home.

While this information is very important to you in terms of budgeting for your home, it may or may not impress the seller if you are hoping to use it as bargaining tool.  The sellers are aware that the mortgage lender is not committed to providing you a home loan as a result of running these numbers for you.  The seller will want more.

Additionally, because the lender did not verify your accounts or debts and in most cases did not pull your credit report, the pre-qualification letter will be chock full of disclaimers.  The pre-qualification statement will be subject to:

• a formal mortgage application
• verification of employment
• verification of assets
• overview of debts
• credit rating and score
• additional underwriting guidelines

Pre-Approved

A mortgage pre-approval takes the pre-qualification process a few steps further.  A pre-approval will impress a seller and will give you even more confidence regarding your home buying budget.  And as a bonus, getting financing out of the way will let you focus on picking the right home in the right neighborhood (the fun part of home buying).

A pre-approval requires a formal application process.  Be prepared to provide:

• pay stubs for last 30 days
• two years tax returns and W-2’s or business tax returns
• proof of other income
• proof of other assets (stocks, pension funds)
• three months of bank records for all accounts
• source of your down payment
• contact information for employers for the last 2 years
• contact information for landlords for the last 2 years
• current debt information: account numbers, payment amounts, balances, etc.

Upon approval you will receive a formal pre-approval letter.  This will be a written commitment from your lender which your sellers will be thrilled to see.  Be aware however, it is not free of conditions, yet.

When the lender pre-approved you, it was only for the amount of money which you can afford for the purchase of your home.  Remember, you have not yet found that home.  When you do, the lender will insist on an appraisal of the property so they can be sure they are not lending you more money than the house is worth.

Additionally, if there is a significant amount of time between your pre-approval and when you find your home, the lender will want to make sure there are no changes in your employment status, financial situation, or credit worthiness.  When you are ready to close on the loan, the lender will re-verify your information.

Your mortgage loan will be fully approved when the appraisal is complete, the title search is done, your information is re-verified and a credit-check is re-run.