Buying a House? Check Your Debt-to-Income Ratio

With the real estate market recovering after the recession, homebuyers face another challenge: approval for home loans. With the introduction of the Qualified Mortgage rules in January 2014 that aim to reduce the risk lenders undertake, borrowers have had a tougher time getting the green light from banks and other financial institutions for the amount they need to buy their dream or even starter homes. As part of these QM rules, lenders will take a closer look at several factors of your ability to repay, including your debt-to-income ratio.

What Is Debt-to-Income Ratio?
Lenders must follow the standards for QM and ability to pay by looking at consumers' monthly debt-to-income ratio, according to a document by the Consumer Financial Protection Bureau. Lenders will consider your existing credit obligations in addition to the expenses that come with owning the home and compare it with your income. Income is considered to be the current or expected income and assets you may have to repay the loan, excluding the property you will live in.

Divide your debt and expenses by your monthly gross income to get your debt-to-income ratio, which is expressed as a percentage.

(Recurring monthly debt ) / (gross monthly income) = debt-to-income ratio

Take this example: you have a recurring monthly debt of $2,000 and you have a gross monthly income of $5,000. You will then have a debt-to-income ratio of 0.4, or 40 percent. 

Before Applying for a Mortgage
As first-time homebuyers navigate the market, real estate professionals often recommend the very first step they take is to get pre-approved for a mortgage. The pre-approval stage will also require that lenders look at your debt-to-income ratio. Lenders and real estate agents know that pre-approval is a crucial step in the homebuying process because it shows homebuyers their budget for homes by indicating how much they can borrow and the amount they can expect in mortgage payments each month. This should give a clear picture of how much house you can afford given your financial standing.

What Goes into Calculating Debt-to-Income?
During underwriting and calculating ability to repay, lenders may look at debt such as:

  • credit card balances
  • student loans
  • and auto payments

They will also factor in your monthly mortgage payment, including:

  • principal and interest
  • property taxes
  • home insurance
  • and homeowners association fees

Other items might also include alimony or child support payments. 

How Lenders Use Debt-to-Income Ratio
According to the CFPB, in reviewing mortgage approval applications, lenders will have to see that consumers' monthly debt-to-income ratios are no more than 43 percent. In the example above, the debt-to-income ratio falls in line with this. However, if you had $500 or more in debt each month in the example, you might be over the ratio needed for approval. If you have a recurring monthly debt of $2,500 instead and you still have a gross monthly income of $5,000, you will then have a debt-to-income ratio of 50 percent. 

Look at Your Financial Documents
Owning a home is one of the biggest financial burdens and accomplishments consumers will have. As buying a home is a major decision, you will have to carefully review your own finances and credit history to determine whether you will fully satisfy the obligations of your mortgage payments. Before submitting your application, look at your own financial documents and determine whether you will have enough funds to support your payments. If you plan ahead, you could also put more money toward paying down any high levels of debt you may still have, such as as student loans or credit card payments. This could help your chances for mortgage approval. In keeping a low debt-to-income ratio, you are better prepared to achieve your goal of owning a home as well as keeping it.