A survey by FICO, the most popular credit scoring system, says the top reason homebuyers get denied is due to debt-to-income ratios, not credit scores.
It’s rare to get a direct view into how lenders see borrowers. When researchers asked a representative sample of what single factor in an application makes them most hesitant to fund a loan request it’s surprising that credit scores are secondary to the amount of debt carried by borrowers.
Homebuyers typically focus on having good credit scores and a sufficient down payment when seeking a mortgage. But nearly 60% of risk managers in the FICO study rated excessive debt-to-income ratios as their No. 1 concern factor.
With this insight on the importance of debt-to-income ratios, homebuyers can make an adjustment to increase chances of getting approved.
Why Debt-to-Income Ratio is Important
Lenders calculate debt-to-income ratio (DTIs) to ensure you have enough income to comfortably pay for a new mortgage while still being able to pay your other monthly debts.
Lenders will analyze two components of debt-to-income ratios:
1. Housing ratio or “front-end ratio”. The anticipated monthly mortgage payment plus other monthly costs of homeownership like monthly housing expenses, homeowner association (HOA) fees, property taxes, mortgage insurance and homeowner’s insurance will be measured against your gross income from all sources before taxes.
Conventional lenders like to see your housing expense ratio come in at no higher than 28% of gross monthly income. If a borrower expects to pay $1,100 in monthly principal and interest, plus $300 in property taxes and homeowners insurance payments, the PITI costs would be $1,400 per month. Thus, the household must have gross monthly income (pre-tax income) of at least $5,000 per month ($1,400 / $5,000 = 28%) to qualify on the front-end ratio.
In some instances there is flexibility to go higher if other elements of your application are viewed as strong.
2. Total debt ratio or “back-end ratio”. In addition to calculating your housing ratio, a lender will also analyze your total debt ratio. This includes all your recurring monthly debts like monthly expenses, credit cards, auto loans, student and personal loans, alimony and child support. The lender will add up all monthly installment and revolving debts in addition to estimated monthly mortgage payment and housing expenses and divide that number by monthly gross income.
Conventional lenders like to see your total debt ratio come in at no higher than 36% of gross monthly income. The borrower with $1,400 in PITI payments might also have a $200 monthly car payment, and a $250 student loan payment; back-end monthly debt payments would tally to $1,850 per month. To qualify under the back-end ratio, this borrower would need to earn at least $5,139 ($1,850 / 0.40 = $5,138.88) in gross monthly income.
For conventional mortgage loans (loans not insured by the government), mortgage lenders are generally looking for 28 percent or lower for the front-end DTI, and 36 percent or lower for the back-end.
FHA allows more flexibility in debt-to-income ratios
Want a larger mortgage? Consider a buying a home with an FHA (Federal Housing Administration) mortgage. FHA has less stringent requirements which generally requires a household to qualify under a 31/43 rule. But this rule is not set in stone. For instance, energy-efficient homes can qualify under an expanded 33/45 rule when financed through the FHA.
For FHA mortgage loans (loans insured by the government), mortgage lenders are looking for 31 percent for the front-end DTI, and 43 percent or lower for the back-end. But they can go higher.
Even though FHA officially sets total debt-to-income ratio at 43%, they also allow for compensating factors. Borrowers with excellent credit and a history of managing similar mortgage payments may qualify with a higher than 43% debt-to-income ratio. On FHA manual underwriting borrowers can sometimes exceed 50% DTI (with compensating factors).
Say no to new debt prior to or during the mortgage application process
Never apply for credit and take on new debt prior to or during the mortgage application process. That includes every type of debt — from credit cards and personal loans to buying a car or financing new furniture.
Most lenders pull your credit report several times during the mortgage loan process and check credit for new accounts. Getting new credit cards and auto loans while home loans are in underwriting is a big no-no.
That’s because your lender will have to factor any new debt into your debt-to-income ratio.
Even merely opening an account — without charging anything to it — can cost you an approval. Don’t increase your credit card balances at all.
The best practice would be to simply avoid opening or applying for any new debts during the six months prior to applying for your mortgage loan and during the mortgage application process.
How to calculate debt-to-income-ratio
Your debt-to-income ratio is fairly simple to calculate: Add up all your monthly debt payments and divide that number by your monthly gross income. For example:
- If your debt costs $2,000 per month and your monthly income equals $6,000, your DTI is $2,000 ÷ $6,000, or 33 percent.
To improve chances of approval at a good interest rate work on your debt-to-income ratios, front-end and back-end, before applying. You may have to postpone your purchase until your DTI won’t be rejected and avoid opening or applying for any new credit during the six months prior to applying for your mortgage loan.