Every loan program has specific DTI requirements. Your debt-to-income ratio shows lenders if you can afford the mortgage or not. Every program has different thresholds. For instance, conventional loans have much stricter debt ratio requirements than FHA loans have. Regardless of the strictness of the rules, they help you and a lender realize just how much of your money is already spoken for each month.
What is a Debt Ratio?
Let’s take a look at the actual definition of the debt ratio. It shows the portion of your income that pays your debts each month. These debts only include those reporting on your credit report, outside of your real estate taxes and homeowner’s insurance. A few examples include:
- Student loans
- Car loans
- Credit card payments
It does not include things like utility payments or insurance payments – only those who report to the credit bureaus.
When lenders calculate your DTI, they use your gross income or your income before taxes. For example, if your total monthly debts before your new mortgage total $750 and your gross monthly income equals $2500, you would calculate your DTI as follows:
750/2500 = .30 or 30%
To complicate matters, there are two types of debt ratios. We will talk about each one in-depth below.
The Two Types of Debt Ratios
The first debt ratio lenders look at is the “front end ratio.” This is the total mortgage payment compared to your gross monthly income. When we say mortgage payment, though, we mean the total mortgage payment. In the case of an FHA loan, this would mean:
- Real Estate Taxes
- Homeowner’s Insurance
- Annual Mortgage Insurance
You must include all aspects of the mortgage payment because they are a monthly liability you must pay. You cannot just stop paying your taxes or insurance – it is a violation of your mortgage agreement.
The second debt ratio is the “back end ratio.” This is the total monthly debts compared to your gross monthly income. This is the proposed mortgage payment plus all debts we discussed above. Any credit cards, student loans, or car loans you have must be included in this ratio. Lenders use the minimum credit card payment the issuer requires as well las the full loan payment for any other loans you have.
The Maximum DTIs for FHA Loans
Now, you need to know the maximum DTI for FHA loans. Technically, it is 31/43. This means your front-end ratio should not exceed 31% and your back-end should not exceed 43%. However, there are exceptions to the rule. In some cases, lenders like smaller ratios and they can require it. They are able to put their own overlays on the FHA rules. In other cases, though, some lenders are more lenient and let certain debt ratios slide, but there must be compensating factors, which we will discuss below.
What if Your Ratios are Higher?
So what happens if you have a 33% front-end debt ratio? Are you out of luck? Some lenders will say “yes,” you cannot get an FHA loan with a 33% front-end ratio. However, other lenders will look at other aspects of your loan. They look for what they call, compensating factors. These are other factors of your application that make your debt ratio less risky.
HUD allows lenders some give and take when it comes to debt ratios. They obviously must use their best judgement. Because the FHA only guarantees the loans and not funds them, they let the lenders decide what they are comfortable funding.
A few examples of compensating factors include:
- Little payment shock – If you can show a history of housing payments similar in size to the proposed FHA loan, it may help you. Showing that you were able to make the payments on time without issue shows the lender you are a good risk despite your slightly higher debt ratio.
- Higher down payment – Putting more than the required 3.5% down on the home could also serve as a compensating factor. The more money you have invested in the home, the less risk the lender takes.
- Great credit – FHA loans are known for their leniency with credit scores, but having a high credit score can benefit you more. The minimum FHA credit score is 580. If you can show a score of 700 or higher, though, you show you are not a huge credit risk and can handle a higher debt ratio.
- Monthly reserves – Having an “emergency” account helps lenders see that you can make your mortgage payment even if your income stops. They will base your savings on the amount of your mortgage payment. For example, if you have $4,000 in savings and your mortgage payment equals $1,000, you have 4 months in reserves. The more reserves you have, the better your chances of approval with a higher debt ratio.
These are the most popular compensating factors lenders use. Each one has a different impact on the outcome of your loan. For example, if you only have 2 months of reserves, yet you have a 39% front-end ratio, the odds are not in your favor. On the other hand, if you have a 700 credit score, 6 months of reserves and a 34% front-end ratio, you may have a better chance at approval.
The key is to shop around with different lenders. There are numerous options out there, each of which accept different risks. Don’t get discouraged if one lender turns you down for your high DTI. Instead, apply with a few others lenders to see who is willing to accept your debt ratio. If you apply for a loan with several lenders within a few weeks of one another, it will not harm your credit score and you will find out who has the best deal for your loan. Each FHA lender has the ability to add their own requirements onto the loan, so do your homework and shop around to find the best deal!