When you apply for a mortgage, your debt-to-income ratio (DTI) will play a vital role. The mortgage lenders will review your credit profile and check the DTI ratio to assess your affordability. So, the debt-to-income ratio will indicate how much debt you carry, such as credit card balances, payday loans, medical bills, personal loans, and utility bills against your monthly income.
Most borrowers know how much their credit score is, which is essential to show their credit affordability. However, many of us need to learn that, like credit score, the debt-to-income ratio will also affect your mortgage loan or credit approval.
What is a mortgage loan?
When you take out a loan to buy your residential home, vacation home, or rental home, it will be called a mortgage.
- Fixed-Rate Mortgage
- Adjustable-Rate (ARM) Mortgage
- Balloon Mortgage
- Interest-Only Mortgage
- Reverse Mortgage
- Combination Mortgage
- Government-Backed Mortgage
- Second Mortgage
The mortgage interest rate depends on the lender and other factors such as your credit rating, earning levels, and, most importantly, the debt-to-income ratio. Now, let’s discuss how the debt-to-income ratio impacts your ability to get a mortgage.
Which ratio do mortgage lenders consider?
There are two types of debt-to-income ratios that most lenders accept while reviewing mortgage applications:
- The front-end ratio is also known as the housing ratio. It also covers monthly mortgage payments, homeowner’s insurance, real estate taxes, and other related costs.
- The back-end ratio will indicate how much of your income is required to pay your monthly debt burden. This may include your credit card bills, car loan installments, student loan payments, medical bills, child support, and other debts in your credit report. This ratio will also include your mortgage payments and other housing expenses.
- 35% or less – You have a decent ratio over your debts and maintain a manageable level.
- 36-49 %—You must improve your DTI ratio by reducing debt levels. This way, you may be able to handle unexpected expenses, such as an expensive car repair, home renovation work, or unanticipated medical costs.
- 50% or more – It is time to get serious! Your DTI ratio has crossed the standard limit and has entered the danger zone. You might need more funds for emergencies. Having such a debt-to-income will reduce your affordability to get a mortgage loan.
Take a Look at the Debt-to-Income ratio
As discussed in the introductory paragraph, the lender can assume the risk factor from the DTI ratio before providing a home loan to a borrower. If the borrower’s debt is too high, the borrower can default on the loan amount.
Usually, the lenders follow a rule that the borrower can have a home loan if the DTI ratio is a maximum of 43% of the particular borrower.
So, a borrower who needs a home loan should repay some debt first. This will help the borrower reduce the DTI (debt-to-income) ratio. Thus, the borrower can qualify for a home loan with a favorable interest rate.
Understand the credit utilization ratio.
Before approving a home loan, lenders check credit scores, which largely depend on the credit utilization ratio. The credit utilization ratio means you have utilized up to what percentage of your credit limit.
Your credit score will be low if you borrow closer to your limit. Thus, your chances of getting approved for a home loan with a favorable interest rate will be lower.
Paying off at least a portion of your credit card debt is a strategy you should adopt. It will help you lower your credit utilization ratio and get approved for a mortgage with a favorable interest rate.
Pay off credit card debt to manage your monthly income.
Remember that your income is limited. Manage your spending and card debt payments with this income. With the monthly mortgage loan payment, a new debt burden will be included in your income. Thus, if you pay off the credit card debts, you will have less debt payment on your shoulders.
Pay off your credit card debts before applying for a mortgage
When you apply for a home loan, the lender will check your credit score and DTI ratio. The interest rate of your home loan will depend on your credit score and the DTI ratio. The lower the lender will offer you an interest rate, the quicker you can pay off the principal balance.
Mortgage options for home buyers
A home buyer should calculate the mortgage loan amount that he or she will have to pay so that he or she may be able to repay the home loan within a definite period.
Fixed-rate mortgage
Fixed-rate mortgage loans are most common among first-time home buyers. A first-time buyer usually takes out this loan for 15 to 30 years. As such, even if the interest rate changes in the market, you will enjoy paying a fixed interest rate on your loan amount.
Adjustable-rate mortgage
This is common among home buyers who would like to pay less initially but agree to accept a change in mortgage payment in the future. This change in mortgage payment may either increase or decrease according to the variation in market interest rate. By choosing this type of mortgage loan, the home buyer will have to make a high mortgage payment in the future if, by chance, the interest rate rises suddenly.
Interest-only mortgage
With the help of an interest-only mortgage loan, you pay only the interest on the loan amount you’ve taken out for a specific period. During this period, you do not have to pay the principal amount. But once the interest-only period ends, your payment amount increases with the repayment of the principal amount. This loan is helpful for those people who earn money on a commission basis.
How to reduce your DTI (Debt-to-Income) ratio
Your high debt-to-income ratio may create issues when you apply for a home mortgage. The higher your DTI, the more likely you may face problems. The lender will only entertain your mortgage loan application if you take significant steps to lower it as soon as possible.
So, here are some steps that you may follow to reduce your DTI:
- You might have to pay off your high-interest debts and the debts with the highest amount. You must pay off credit card debts, payday loans, student loans, or other outstanding debts. Increase the amount of your down payment every month to lower your total debt amount. If you have financial problems but still need to reduce your DTI, it will be wise to opt for debt settlement.
- Your debt-to-income ratio is high just because you have too much debt on your shoulders. So, the easiest way to improve DTI is to cut off a big chunk of debt. You may pay off your current loans ahead of schedule, at least one or two. But before paying, know everything about pre-penalties.
- Refinancing your existing loans at lower interest rates can be an outstanding move to lower your DTI. You must qualify for a lower interest rate and modify your repayment terms. Online lenders like SoFi and Earnest may offer you better interest rates. Once you can lower interest rates and reduce your monthly payments, your DTI ratio will gradually reduce.
Conclusion
Whether or not you can afford a home loan payment, your lender will come to know about it when they check your credit score and DTI ratio. When you show an impressive credit score and DTI ratio to your lender, chances are you can get a home loan with a favorable interest rate. Thus, paying off your credit card debt before applying for a mortgage is important.
About the Author: Lyle Solomon has extensive legal experience, in-depth knowledge, and experience in consumer finance and writing. He has been a member of the California State Bar since 2003. He graduated from the University of the Pacific’s McGeorge School of Law in Sacramento, California, in 1998 and currently works for the Oak View Law Group in California as a principal attorney.
