Obviously, one can’t spend an entire month’s salary on the mortgage bill. There are other debts to take care of – including car loans and credit cards – as well as everyday expenses like groceries and gas. Just like you, a careful lender wants to make sure you have enough money on hand each month to cover your home loan.
That’s why a lender will examine every loan applicant’s debt-to-income ratio. The name is pretty self-explanatory: Your debt-to-income ratio compares how much money you owe to how much money you earn. From this, a lender determines what kind of loan you can actually afford. The lower the debt-to-income ratio the less risk to the lender since the borrower more likely has the capacity to make the required payment.
Traditionally, an ideal mortgage payment would be no more than 28% of your gross monthly income. If, for example, your total monthly salary were $4,000, you would want to pay no more than $1,120 for your mortgage payment, including principal, interest, property taxes and insurance (PITI). This is called your housing ratio, sometimes referred to as your “front end” debt-to-income ratio.
Another common ratio reviewed by the lender is referred to as the “back end” or total debt-to-income ratio. This includes the mortgage payment (PITI) just mentioned as well as other fixed monthly debts listed on your credit report. It does not take into consideration other variable expenses such as utilities, groceries and daycare expenses, to name a few, since they do not appear on your credit report. The “back end” ratio has changed over the years, but a 40% debt-to-income ratio is typically acceptable to qualify for the best terms available. If your debt-to-income ratio exceeds this number, you might be required to pay a higher rate of interest than the best rates available in the market for your loan.
But keep in mind that your debt-to-income ratio is just one variable. Even though you may not meet the standards noted above, there are plenty of loan options and competitive rates available to meet your specific needs. The types of loans may be referred to as non-conforming or sub-prime loans. The interest rates with these types of loan options have become very competitive in today’s marketplace, especially since the majority do not require mortgage insurance (MI or PMI). Also keep in mind that these percentages are not set in stone, especially if you have compensating factors that the lenders look at favorably, such as a large reserve balance in a 401(k) or other investment account, or quite possibly a very high FICO score on your credit report.
Therefore, it is essential to contact a mortgage professional and allow him or her to review your individual situation to determine the best available solution for your needs and objectives.
