When it comes to home buying, there are a number of different factors a lender considers. Beyond the standard credit score, they're also looking at the buyer's total financial history—including the entirety of their assets, income, and debt. The debt-to-income (DTI) ratio is a major factor when it comes to the approval chances for a buyer. Why is the DTI ration significant, how do lenders calculate it, and what can home buyers can do to improve their ratio?
What Is the Debt-to-Income Ratio?
The debt-to-income ratio calculates the buyer's total debt against their total income. It's calculated on a per month basis and includes everything from the cost of the mortgage to all recorded monthly debt. Buyers measure this debt against their gross monthly income (before taxes are applied). From student loans to credit card bills to car loans, buyers need to provide all of the requested numbers to their potential lender. Lenders are generally not allowed to take into account how much the homeowner pays for transportation, health insurance, grocery bills, and standard utilities. However, buyers should have an idea of what their bills and expenses will look like before applying for different types of loans.
Lenders will look at the total percentage of debt to monthly income as a way to determine how likely it is a buyer will be able to pay their monthly mortgage on a timely basis. Those with a high ratio of debt are more likely to find themselves in a situation where they have to choose between their student loan bill or mortgage payments. Because emergencies will arise, lenders have to be sure that buyers have enough of a financial cushion to keep up with their repayment schedule. Buyers are looking for a low percentage, preferably somewhere around 36% (or lower) to have the best chance of getting the loan they want.
Details and Exceptions
Buyers with a higher debt ratio should keep the following in mind:
- While 36% is closer to the ideal ratio, home buyers with a ratio as high as 43% may still be able to secure a loan.
- Home buyers with a ratio of 43% or higher may still be able to get a Qualified Mortgage if they go through a small creditor. (Small creditors are generally defined as lenders who give out less than 500 mortgages a year with under $2 billion in total assets.)
- Lenders look at the ability of homeowners to make ends meet based on their credit score and financial history, meaning DTI is not the only factor in the lender's decision.
Advice and Recommendations
The best thing a Clarksville TN home buyer can do to improve their DTI score is to avoid taking on any new debt or by paying some of their original debts off. Paying additional debts works for the buyer in two different ways. First, it lowers the amount of debt a buyer has, thereby reducing the ratio to a more attractive number for the lender. Second, it can also improve the credit score of a buyer. The DTI does not factor into the terms of the loan, but the credit score will. This two-pronged approach is a smart move for buyers who may need help in both areas.
When it comes to buying a home, lenders look at a variety of factors when assessing a buyer's ability to repay both the interest and the principal of the loan. Understanding how they arrive at their decisions can make it easier for buyers to plan ahead.
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