Along with credit score and total assets, the debt-to-income (DTI) ratio is an important component for lenders. Even people with perfect credit scores can be turned down from their dream mortgage if their debt is too high in proportion to their income. It is important to not only understand what the DTI ratio is, but also discuss other aspects of the sometimes confusing mortgage process with a mortgage lender prior to searching for a new home to purchase. How can potential home buyers become a more attractive candidate for a loan?
What Exactly Is DTI?
When lenders calculate your debt-to-income ratio, or DTI, they take a lot of numbers into consideration. Your DTI is actually composed of two different figures; one is referred to as the front-end and one is the back-end.
In simple terms, the front-end ratio is the cost of your housing divided by your monthly income before taxes. This number is attempting to generate an idea of how much of your paycheck would be taken up by your mortgage. Lenders typically like to see your front-end DTI below 28 percent.
The back-end DTI addresses your debt and aims to make sure you aren’t stretching yourself too thin with a mortgage payment. The sum of all of your debt plus your housing costs would be divided by your gross income. If this number is above 36 percent, you might not get the mortgage you were hoping for.
How DTI Is Calculated
The DTI ratio totals all of the buyer's debt and then divides the number by the buyer's gross monthly income. In this case, debt does not include insurance, utility or grocery bills, but it does include all credit card bills, car loans, and student loans. The ideal DTI ratio is 43% or under. Lenders want to see that buyers have plenty of financial cushion in the case they lose their job or another significant source of income. Buyers should total up their DTI well before they step foot in a lender's office or make a phone call to a broker.
Behind the Numbers
Canada's average DTI ratio has gone through a major spike in just the last 10 years. The average household income ratio is 171.1%, which is alarming to lenders for a number of reasons. Despite precautionary measures such as Lenders Mortgage Insurance (LMI), lenders still fear the financial and practical ramifications of a default. For this reason, buyers need to be aware of the terms before agreeing to a loan. A slightly higher interest rate may look perfectly reasonable to a buyer at first glance, until they realize that a fraction of a percentage point can result in tens of thousands of extra dollars spent over the course of a 30-year loan.
Doing the Math
A South Calgary home buyer's DTI is calculated prior to taxes being taken out, but buyers will need to factor in taxes when settling on a budget. For example, if a buyer is making around $5,000 every month, then they're likely spending between $900 – $1,000 on taxes. If they only have $1,000 left after paying off their average credit card bill, student loans, and home mortgage, then they won't have very much left for savings.
Home buyers need to take into account everything from their entertainment budget to their retirement goals before they decide the price range of the home they want. No matter what a person's DTI is though, they're highly encouraged to shop around to both large and small creditors alike in their area. Consulting with a broker can also be a smart move, as brokers often have access to products that would take buyers hours to research.
How Can A DTI Change?
If your lender determines that your DTI is too high, it doesn’t mean you can’t buy a home. In fact, there are several options available for modifying your DTI to bring it into an acceptable range. This can be addressed from a variety of perspectives, like raising your income or lowering your obligations.
Sometimes people choose to take on a second job just to boost their income enough to lower their DTI. This could be a potential short term option if you really want the Calgary house of your dreams, but make sure you’ll be able to keep up with expenses if you decide to quit.
Others try to work extra hours to pay down debt so that their back-end DTI is lower. If the problem is within the front-end DTI, it might mean that your budget needs to be scaled back a bit. Shopping for a lower priced home obviously results in a lower mortgage payment, and this will have a positive effect on the front-end DTI.
How to Lower DTI
One thing buyers can do to lower their DTI is to pay off their debts as much as possible (and avoid taking on any new ones). Not only will eliminating some of the debt lower the total ratio, but it can also boost a buyer's credit score as well. Consulting with a real estate agent or a financial planner can make it easier to determine how much work needs to be done before the buyer can secure the loan they want.
How A Higher Down Payment Can Make It Easier To Qualify For A Home When You Have High DTI
A high debt to income ratio can make it difficult to qualify for a mortgage that is enough to purchase the property one wants. Mortgage limits are calculated looking at an individual's debt to income ratio. If the ratio is high, it is determined that the individual is not able to afford as high of a mortgage payment than if the debt is low and the income is high.
One way individuals are able to afford a home that is more expensive than their debt to income ratio will allow them to borrow is to pay a higher down payment. When one is limited in the amount of money that can be borrowed with a mortgage, one way to afford a more expensive property is to cover the additional money with a down payment. The other way to qualify for a higher home mortgage is to either raise income, lower debt or do a combination of both.
When a higher down payment is put down on a property, the borrower doesn't have to qualify for mortgage insurance if the down payment is 20% of the purchase price or more. This can make a mortgage more affordable without the additional cost of the insurance and give a borrower the opportunity to qualify for a better mortgage rate.
Prepare Before Applying
It’s drilled into our heads from a young age, but it really is true that being responsible with credit has its rewards. Being really excited about purchasing a City Centre home doesn’t mean you have to eat ramen every day and keep the lights off all of the time. As long as both the front-end and back-end DTI ratios are within allowable limits, your application should proceed with no problem. Remember, if your ratios are too high, there are steps to take to bring these numbers to an acceptable range.
DTI isn't the only important number for a home buyer, but it is an indicator of how well a person can manage their finances. Once a buyer knows their ratio, they'll have a better idea of the terms and conditions they can expect from lenders and what they can do to improve their chances of approval.