The Lender’s Debt-to-Income Sweet Spot: Q&A with Cara Pierce

January 14, 2015 | By

Debt-to-income ratio, or DTI, may be an unfamiliar term to some prospective borrowers — and that oversight can be costly. According to a recent article in The Washington Post, most mortgage lenders consider DTI ratios, not credit scores, to be the most worrisome factor for mortgage applicants. It may determine whether you’re approved for a mortgage, and how much money you can borrow.

Like a winning golf score, a low DTI ratio is desirable, say experts. So what’s a low DTI? And what do you do if yours is too high?

To find out more about the importance of the DTI ratio, The Home Story spoke with Cara Pierce, who’s worked as a housing financial specialist with Atlanta-based ClearPoint Credit Counseling Solutions for 18 years. Pierce sheds light on how the DTI ratio is calculated, why it’s important, and how to lower your DTI ratio in the event that you need to.

The Home Story: What exactly is a debt-to-income ratio?

Pierce: Debt-to-income ratio is a comparison of the total amount you’d pay monthly if you paid only the minimum payments on all of your revolving and installment accounts (like car loans and credit cards), in relationship to your gross income. Gross income is what you earn before taxes, insurance, or retirement fund contributions are taken out. It’s also referred to as “pre-tax” income.

THS: How do mortgage lenders calculate DTI?

Pierce: Mortgage lenders use your credit report to view credit account balances, your payment history, and minimum payment amounts. They’ll add the minimum monthly payments from all of your accounts together and compare that number against your gross income. So if your debt obligation is 25 percent of your income, your DTI is 25.

THS: What about accounts that are nearly paid off?

Pierce: If an existing account will be paid off shortly, say in less than six months, many mortgage lenders won’t include that obligation in your DTI calculation. If you have questions, you can ask your lender about the account.

THS: What if you pay more than the monthly payment each month? Do they adjust for that?

Pierce: No. Although paying a little more is smart because you’ll pay down your debt faster, it’s not something the lender will use in the DTI calculation. They just look at the minimum required payments.

THS: What about other monthly payments like utilities or food costs? Are they added in too?

Pierce: No. Discretionary spending, such as what you pay for utilities, food, clothing, and entertainment, isn’t part of the DTI calculation.

THS: Why is DTI so important?

Pierce: Your DTI helps the lender determine how much they will loan you. If you are already using 40 percent or more of your gross income to pay car payments and credit cards, that leaves less than 60% for other your household spending (like your phone bill, utilities, and transportation) and house payment.

THS: What would be considered an acceptable DTI ratio?

Pierce: Mortgage lenders generally follow the 28/36 rule for conventional loans (loans not insured by the government). The first number is the “front-end” ratio. The second number is the “back-end” ratio.

The front-end ratio describes how much of your gross income would go to paying your house payments like your mortgage payment, taxes and insurance, and not including other debt. The back-end ratio describes how much of your income goes to paying your total debt – whatever the house payment would be plus minimum payments on credit cards, auto loans, etc.

So the 28/36 rule means they are generally looking for DTI numbers in that range or lower. Some lenders may be a little stricter and others less so.

THS: What’s more important? The first or second number?

Pierce: Lenders are concerned about both ratios — either one being too high could keep you from qualifying. Lenders want to be sure you can afford the loan payments.

THS: What about DTI for other loan types like FHA loans (insured by the U.S. Federal Housing Administration)?

Pierce: The DTI for FHA loans can be slightly higher. Again, it depends on the lender.

THS: What do you think of the study cited in The Washington Post that DTI is the most concerning factor for lenders, not credit score, in evaluating loan applicants?

Pierce: That doesn’t surprise me. The credit score shows how well you have paid your debts in the past. If you pay at least the minimum payment every month, don’t have too much debt, etc. you should have a good credit score. However, the DTI really looks at your capacity or your ability to pay. My husband and I have good credit, but even with good credit, we couldn’t qualify for a home loan of $750,000. Our credit may be good, but we don’t make enough to afford a house payment that large.

THS: Should borrowers know their DTI in advance of talking to lenders?

Pierce: Absolutely. By law, you can request a free copy of your credit report annually at AnnualCreditReport.com or by calling 877-322-8228, and you can do the calculation yourself. There are many online calculators, including Fannie Mae’s DTI calculator.

THS: If you calculate your DTI and it’s too high, what should you do?

Pierce: To improve your DTI, you’ll need to pay down debt. Even paying a little over the minimum payment each month on accounts will help. If you have a $100 a month payment and can’t afford $200, just pay $125. That will make it faster for you to pay off the debt.

The lender has to see that this loan is going to be affordable for you. They have to know you’ll be able to afford your monthly payments in addition to the down payment, closing costs, and your other monthly commitments.

THS: Any other advice for would-be homeowners?

Pierce: Along with paying down debt, you’ll need to save for the down payment and closing costs, and that can be a struggle for some borrowers. My advice is to pay yourself first, like you are a bill, to save. So instead of looking (at) what you have left after you pay bills, you make that payment, to your savings, as part of your monthly bill-paying routine.

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