I'll answer that question at the end of this post. I think it is important to cover the basics first.
What is a debt-to-income ratio?Debt-to-income ratio (DTI) is just another way of saying money out vs. money in each month. Lenders use it in order to determine whether they believe a borrower will be able to reasonably repay a loan.
Which debts are included?The debt portion of a DTI ratio is calculated by adding the amount of monthly payments on all recurring debts. These debts are almost always included:
- Car payments
- Minimum credit card payments
- Expenses for the home being purchased or refinanced
- Expenses for other real estate owned
- Student loans
- Child support
- Alimony/spousal support
- Other installment loans (boat, RV, recreational vehicles, lines of credit, etc.)
For the most part, if a debt shows up on your credit report, it is included. Utilities are not included in debt-to-income ratios, so phone, electric, water, gas, and other utilities are usually not considered.
It is worth noting that all costs of real estate owned are part of the DTI ratio. This means that property taxes, homeowner's insurance, mortgage insurance and homeowner's association dues are all included for each property owned (if they are applicable).
How is income calculated?The income portion of the DTI ratio is calculated for mortgages by using gross income (pre-tax). Almost any type of income can be used as long as it has a documentable history and the reasonable expectation that it will continue for at least 3 more years. For employment income, most programs and lenders will want to see a 2 year history of income, but special situations and types of income may be considered with less than 2 year history. These are some typical income sources used in the debt-to-income ratio:
- W2 salaried or hourly income
- Bonus income
- Commission income
- Self-employed income
- Social Security income
- Pension income
- Rental income
- Child support income
- Alimony/spousal support income
The calculation for some of these types of income varies by program and lender and could be an article topic of its own. Salaried, social security, pension, child support and alimony income are all pretty straightforward - simply divide the annual amount by 12. To determine exactly how the other income sources are used in the DTI ratio, consult a reputable lender and let them do the work for you.
So...what is a good debt-to-income ratio?Different loan types (i.e. FHA, conforming, VA, USDA, jumbo) have different acceptable ratios. A very general rule of thumb is 43%, but this is not set in stone.If your DTI ratio is 43% or lower, you should qualify for nearly every program available. It is possible to qualify for programs above 43%, even after the recent changes in the mortgage industry. Certain loan programs allow higher debt-to-income ratios if the loan receives an automated loan approval or a lender may have its own separate program beyond the standard loan types mentioned.
To find out which programs you would qualify for, simply pick up the phone and call a lender (hint: I'd love to be that lender).
A quick example debt-to-income ratio calculation:Here is a very simple debt-to-income ratio calculation. Susan has a salaried income of $5,000 per month. She has a car payment of $500 per month and her credit card minimum payments add up to $100 per month. The home she is hoping to purchase has a proposed monthly payment of $1,300. These are her only monthly debt and income sources.
- Susan's monthly income is $5,000
- Susan's monthly debts are $500 + $100 + $1,300 = $1,900
- Susan's debt-to-income ratio is 38% ($1,900 / $5,000 = .38)
- Susan should qualify for any loan program with her DTI at 38%
I hope that helps clear up some of the confusion surrounding debt-to-income ratios and how they are used to qualify or disqualify prospective borrowers. Please feel free to reach out to me with any questions or if you would like help calculating your DTI ratio.
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