Defining debt to income ratio for mortgage
The debt to income ratio refers to the total monthly debt payments relative to the gross monthly pay. It is one of the most crucial factors that mortgage lenders use to analyze your creditworthiness when applying for a home loan. They need to know if you can actually manage the payments every month and repay the loan in good time.
How is a debt to income ratio (DTI) determined?
Are you worried that your financial position cannot allow you to purchase a house? Take a close look at what mortgage lenders think is the ideal the ideal income to debt ratio.
To calculate the DTI ratio, divide your recurring monthly debt payments by your gross monthly income. The resulting quotient is your potential mortgage burden. It gives a clear picture of how you will manage the loan and allows the lender to predict if you can complete the mortgage bill payments. Note that the gross income means the amount of money earned before taxation or other deductions. The DTI ratio doesn’t put into account the money you pay for daily expenses e.g. car insurance premiums or grocery expenses. Other monthly bills that count include credit payments, child support, rent, and student loan. If you think you are ready for a mortgage, you must figure out how it is going to affect your budget.
Suppose you have an auto loan that requires $900 per month, a $500 per month for a personal loan, and $1,100 for a mortgage. Your overall monthly debt burden is $2,500. If your monthly gross income is $5,000, your DTI ratio is (2500/5000)*100 = 50%.
What is the acceptable DTI in Canada?
Statistics indicate that home buyers with a high DTI are more likely to default their mortgage payments. The acceptable ratio by most lender falls between 30% and 45%. If your DTI is 50%, you should consider consulting a debt expert because it is not a healthy financial position. But there are certain exceptions when you approach a small mortgage lender who might give you a loan with a DTI above 45%. Big lenders might provide a mortgage if your DTI is more than 45% but you must demonstrate the ability to repay the loan. You need, for instance, excellent credit score or make a bigger down payment.
How to improve your DTI
The key to determining how much mortgage you can afford is knowing your debt to income ratio. This is a vital aspect which underwriters take into consideration to see how well you can handle a loan. Bearing in mind its significance in the lending industry, it is imperative to understand how you can improve it.
The good news is that DTI can be improved, unlike other areas of financial life. If you pay off some of your excess debt like students loan, you can lower it to a healthier level. Before you start making mortgage payments, check with your lenders as requirements can differ significantly.
By paying down your debts, you can reduce the DTI. Pay off any credit card dues so your gross income can improve. Your lender may not be aware of your side hassle so you can use the extra income to reduce your debts. Moreover, you can use your bonus pays and cash windfall to minimize your debt burden. Note that your student loan is included in the calculation of DTI. The type of loan plus whether it has been deferred will determine whether the student loan counts against you.
Other expenses
Mortgage lenders have to review your recurrent monthly expenses like condo dues and homeowners association charges; insurance and mortgage premiums, and other financial obligations. Even if you have a great credit score, your debt to income ratio is equally important. Mortgage lenders have to look at the greater picture to see if you are capable of managing a plethora of monthly bills.
Types of debt income ratios
Lenders use two types of DTI ratios to determine your eligibility for a mortgage.
- Front-end DTI: this is the first ratio that mortgage lenders use. It is the proposed overall monthly payments of your housing (which include insurance premium, property taxes, and new mortgage installments) relative to the gross monthly salary.
- Total debt ratio: it is another important ratio in addition to the housing payments. It takes into account all the other monthly financial obligations like credit card loans, student loans, and auto loans.
Once you know your DTI, you can finally know what type of home loan you qualify for and how much you can save per month. Talk to an expert to help you with the grunt work of canceling mortgages that are too much out of your league. Then, focus on home loans which match your financial position.
Conclusion
Banks prefer mortgage clients with low DTI. Ratios above 45% are considered risky. Borrowers with DTIs as low as 36% have higher chances of qualifying for low-interest mortgages. If you are trying to acquire mortgage with better terms, your best bet is to keep your DTI as low as possible (below 36%). If you are stuck on how to calculate the ideal DTI and how it will affect your ability to get a home loan, talking to a financial advisor would be a good option. Don’t forget to use other smart tools to find a mortgage that meets your needs. Such tools help you to compare the mortgage rates thereby allowing you to find a good fit. A DTI ration is a good heads-up for considering a home that suits well your budget. In the end, you want a happy ending by making a major financial purchase. Check out how much mortgage you can afford.
