In the wake of the home finance crisis that began in about 2008, obtaining a mortgage is now more difficult than it was before, but knowing the obstacles will help prepare you for buying a home. Today’s lenders want to avoid the mistakes that bankrupted yesterday’s lenders. Additionally, Government Sponsored Entities (GSEs) Fannie Mae and Freddie Mac have set much tighter guidelines that lenders must follow. There are numerous factors considered when determining eligibility for a mortgage, but the three big ones are credit history, income and debt.
The debt-to-income ratio (DTI) is a valuable number that underwriters look at heavily when determining your borrowing ability. To put it simply, DTI is the amount of debt you have compared to your overall income. A low DTI shows lenders that you have a favorable balance between debt and income.
There are two main kinds of DTI and they’re expressed as a pair (front-end/back-end). The front-end ratio indicates the percentage of income that goes towards housing costs (principal and interest, mortgage insurance, property taxes and homeowners’ association dues). The back-end ratio is the percentage of income that goes towards paying recurring debts, including the housing costs covered in the front-end, plus credit card payments, car payments, student loans, child support, alimony, etc. AmeriSave, one of the nation’s largest online lenders generally requires a DTI of 45% or lower for conventional conforming loans.
If you haven’t guessed it yet, one of the keys to unlocking the door of homeownership is reducing your debt-to-income ratio. There are many things you can do to actively reduce your DTI so you can apply for a mortgage.
Increase your income – This might mean working some overtime, asking for a salary increase or taking on a part-time job. Be advised though, as we mentioned earlier, income verification standards have increased greatly in the new age of lending so be mindful that cash or otherwise non-reported earnings will likely not count toward your “income”; although it could be used to reduce debt to the same effect.
Reduce spending – Review your bank and credit card statements to see where you are spending most of your money. Cut back on unnecessary expenses and research other providers of insurance, phone, cable and other utilities to see if there are lower-cost alternatives. Plow those savings into reducing your debt.
Reduce debt – A high DTI is not necessarily bad if you’re actively reducing debt. For example, if your income is $2000 per month and you’re putting $1000 towards debts, your DTI is temporarily 50%, but will be reduced to 0% when you’re finished. If you have any cash saved, you might want to consider paying off some debt. While credit cards have high interest rates, the minimum payments are typically lower than, say an auto loan. Consider this scenario:
You have credit card debt of $5000 with a minimum payment of $120 and an auto loan with $5000 remaining and a payment of $600. The $600 per month towards the auto loan reduces your borrowing power by $100,000, so you may want to consider using the savings to eliminate the auto loan and continue paying monthly towards the credit card.
If you plan on paying off any debts in full, ask the creditor the date they report to the credit bureaus, then apply for the mortgage after your account has been updated, revealing less debt. You can also track changes to your credit report with free services like Credit Karma.