After your credit score, lenders pay close attention to your DTI or debt-to-income ratio. This is the comparison of your debts to your gross monthly income. It’s the lender’s job to make sure that you don’t take on a payment that you can’t handle and the DTI is the best way to do it.
Each loan program, including the FHA loan, has a maximum debt-to-income ratio. In fact, they have two max DTIs, the front-end ratio and the back-end ratio. Keep reading to learn what they mean and how they affect your ability to secure a mortgage.
The Max FHA Front-End Ratio
The front-end ratio is also known as the housing ratio. This is a comparison of your total housing payment to your gross monthly income. The lender compares the cost of the principal, interest, taxes, homeowner’s insurance, and mortgage insurance to your gross monthly income. This is the income that you make before taxes (it’s not your take-home pay).
Typically, the FHA likes this payment to be 31% or less of your gross monthly income. For example, if you make $6,000 per month in gross income, you could have a housing payment of at least $1,860. Now keep in mind that this isn’t just the principal and interest. You also have to include the monthly cost of your annual property taxes, the monthly cost of your annual homeowner’s insurance, and the cost of your monthly mortgage insurance charged by the FHA.
The Max FHA Back-End Ratio
The back-end ratio is the total debt ratio. This is the comparison of all of your monthly debts to your gross monthly income. Your total monthly debts include:
- The potential mortgage payment
- Any minimum credit card payments
- Any installment loan payments
- Any student loan payments
- Any car loan payments
Basically, any payment that reports on your credit report is included. Things like utilities, insurance, and tuition aren’t included.
The max FHA back-end ratio is equal to 41% in general. However, it’s not unheard of for the FHA to allow a back-end debt ratio of 50%, but with compensating factors. We’ll discuss what those are down below. It’s a good idea to see which debts you can eliminate before you apply for an FHA mortgage so that you can maximize the amount of the housing payment that you can qualify to receive. The lender needs to know beyond are reasonable doubt that you can afford the housing payment.
Compensating Factors and How They Help
We discussed the need for compensating factors above. You need these when one of your factors, such as the DTI, doesn’t meet the FHA requirements. If you have other factors that make your loan a low risk of default, the lender may let something like a higher debt ratio through.
So what compensating factors can you have? Some of the below may help:
- High credit score – You only need a credit score of 580 to get an FHA loan. That’s pretty low. If you want to get a higher DTI through, you should try maximizing your credit score. Typically, a score higher than 700 is considered ‘great.’
- Stable employment – FHA lenders are supposed to look for a 2-year employment history. They like it when you are at the same job during that entire two years too. It shows stability and reliability. This doesn’t mean if you changed jobs less than two years ago that you can’t get an FHA mortgage, but you may have an easier time if you have a high DTI, if you kept the same job.
- Increasing income – Lenders also like to see steadily increasing income over the past two years. Even if you changed jobs, if you did so to take a higher paying job, it can work to your benefit. Reliable income that steadily increases lowers your risk of default.
- No negative credit history – Technically, lenders focus on the last two years of your financial life, but some may look back further. If you have a flawless credit history, but have a higher DTI, lenders may not be as nervous to give you the larger loan because of your flawless credit history.
In reality, you should stick to the 31/41 total debt ratio requirements for FHA loans, but know that there are ways around it. If you know that you have a high debt ratio, focus on your other factors to make sure that they are good enough for the lender to overlook your high DTI.