Quick Shot: DTI ratio (Debt to Income) loan qualifying
Some quick basics: There are two components of any DTI – the “front-end” ratio and the “back-end” ratio. Both compare recurring monthly debts against stable, documented and regular monthly income. These are both used no matter what amount of down payment you intend to apply since a higher down payment will already be taken into account as a lower monthly P&I mortgage payment.
Remember: lenders look at two years worth of income and steady employment, not a year’s worth or the upcoming year’s worth of “projected” income. Also, people who work multiple jobs, have highly variable monthly incomes and many self-employed borrowers present special problems in establishing acceptable “income” for the lender’s underwriting purposes and may have more difficulty getting a loan approved. All lenders require two years of tax returns and two months of ALL bank statements and the last two payment stubs from all borrowers. (Not having filed “yet” will not be acceptable, so plan ahead.) Many lenders will have additional criteria (like two years of time in your current job regardless of the amount of time you have had steady income). It is always good to shop around for a mortgage to not only shop for better rates, but also to be flexible if there are any chances you may run into one of these other potential “gotchas.”
The front-end DTI covers housing related expenses, starting with the monthly principal, interest, taxes and insurance on the loan your prospect is seeking. It can also include homeowner or condo association dues if they are paid monthly.
The back-end ratio, which covers buyers’ total months debt obligations, adds their monthly housing payments together with other recurring payments – credit cards, auto leases or loans, child support or alimony, student loans, bank loans and the like.
The totals of each type are then compared with their gross monthly income, not including gifts or irregular income.
As a general rule, keep in mind these DTI MAXIMUM percentages (FE/BE): 31/43 percent, 33/45 percent and 33/50 percent for back end DTI. Federal “qualified mortgage” guidelines that many lenders follow set a 43 percent upper limit on back-end DTIs. Fannie Mae and Freddie Mac use a slightly more generous max of 45 percent. FHA can go higher – 50 percent and, with buyer “compensating factors”, even as high as 56.99 percent on the back end.
HOWEVER, many lenders “prefer” the back-end DTI to be no more than 36% regardless of the Federal maximum limits. Each lender is free to set their own loan requirements and interest rates based on their own in-house criteria so long as the criteria is applied in a non-discriminatory manner to all applicants for a home loan. So, even if you qualify under federal guidelines, being close to the limits may result in your finding it difficult to attain a loan at all, and if you do, it may be at a higher rate than the generally advertised “teaser” rates provided only to those with the best credit.
NOTE: On VA Loans, the only ratio used is the back-end (DTI) which cannot exceed 41%; VA has no front-end requirement and there is no down payment requirement for first time VA loan users (there is a reasonable “fee.”) This makes VA loans an excellent alternative for any qualifying veteran or active duty personnel. However, VA loans still will have several thousand dollars of costs (like all loans have) that must be paid at closing.
So, as a general example, buyers with gross monthly incomes of $5,000 probably should NOT have more than a total monthly debt obligation above $2,050 (41% DTI) if they are seeking a VA loan; or no more than $2,150 (43% DTI) or $2,250 (45% DTI) if they are seeking conventional loans; and no more than $2,500 (50% DTI) if they’re going FHA. Obviously, it is much better to have a cushion and not be “on the line.” Remember, ALL debts are included, even debts you will not incur until you buy a home such as annual insurance and property taxes, HOA fees and any other ongoing assessments that may already be on the home (e.g. ongoing payments due for solar panels) or Special District assessments by the city or county (new sidewalks, etc).
Bottom line: If you are not already fully qualified with a lender for a maximum loan amount, a heart-to-heart and honest discussion needs to be had between us to enable me to come up with a likely price range for each potential client’s DTI situation. That, in turn, should help signal whether you can really afford the houses you say you want to look at. For many, a quick DTI litmus test could save a lot of time and frustration and will allow me to continue to help you find and buy the “home of your dreams.”