Most people are familiar with a credit score – they probably even know what their personal credit score is. It’s a pretty simple concept; a good credit score will get you loans and more credit. A bad credit score will get you … nothing really.
But, for some home shoppers, seeing their mortgage application denied when they have a good credit score is baffling. And, the reason the application was denied is even more confusion – their debt-to-income ratio.
According to financial research groups, more than half of all consumers don’t know what a debt-to-income ratio is or why it’s important.
In 2016, the number one reason that mortgage loan applications were denied was due to high debt-to-income ratio. Confusing, right? A high credit score is a good thing but a high debt-to-income ratio is bad.
What is DTI?
Basically, your DTI number is calculated by taking your debt payments and dividing them by your gross monthly income. In other words, how much income do you have available after your current monthly debt?
There are two ways this is calculated; First, a lender will add together all of your projected house expenses. This includes things like the mortgage payment, property taxes, home owner’s insurance, etc. This total amount is then divided by your gross monthly income. This is your front-end DTI
Next, the same calculations are done using all of your currently monthly expenses. This is your backend DTI.
Most lenders want to see that your front-end DTI is 28% or lower and your back end is somewhere around 36% or lower.
Why is DTI important?
While a good credit shows that you are good about paying your debts, it doesn’t really show how much debt you can handle. That’s where the DTI comes in – it tells lenders how much money they should lend you based on how much money you can pay back on a monthly basis.
So, if you’re looking for a home that is in the $350,000 range but, you’re currently using 22% of your front-end DTI for living expenses and 39% of your backend DTI on your monthly bills – a lender is unlikely to loan you that substantial of an amount.
Can I lower my DTI?
Yes! There are two ways that you can lower your DTI.
First, pay down your debt. If your back-end DTI is high, it’s because your monthly bills are high. If you have several credit cards that have balances on them, you have an auto loan, maybe a couple of students loans – all of these could be paid off and that would dramatically reduce your DTI.
The other way to reduce your DTI is to increase your income. If you can get a raise at work or take on a second job, you can increase your income and that would make the number that the debt is divided by bigger – leaving the percentage lower.
If you are in the market to buy a house and you are considering filling out mortgage applications – make sure that you know what your DTI is. If it is lower than the recommended percentages than you’re in good shape.
But, if it is higher, then you might consider paying off some of your monthly debt before you take the time to complete those applications to make sure you have the best chance of getting approved.