Lenders look at two main factors when deciding if you can afford a home loan – your credit score and your debt-to-income ratio. Of course, they look at other factors too, but these are the most important. If you have a low credit score or a high DTI, it automatically sends up a red flag, making it harder to get the loan qualification you need.
Does this mean you can’t qualify for a home if your debt ratio is high? Luckily, there are a few things you can do to make it better.
Figuring Out Your DTI
Before you ever apply for a loan, calculate your own debt-to-income ratio. All you need is your gross monthly income and your total monthly liabilities.
Your gross monthly income is your income before taxes. If you make an annual salary, take that amount and divide it by 12. If you are paid hourly, take your hourly wage, multiply it by 40 (if you work full-time), and multiply that number by 52. Finally, divide that total by 12 to get your gross monthly income.
Here are two examples:
- If you make $60,000 per year, your gross monthly income is $5,000 ($6,000/12)
- If you make $30 per hour, your gross monthly income is $5,200 ($30 x 40) x 52/12
Next, tally up your monthly liabilities. These are only the debts that report on your credit report. Think of things like:
- Car payments
- Student loans
- Credit card payments
- Mortgage liabilities
- Personal loans
You then divide the total debts by your gross monthly income. Let’s say your monthly debt total is $1,000. Using the above examples, your current DTI would be:
- $60,000 salary – 20%
- $30 per hour – 19%
This is just your monthly debts outside of the potential mortgage, though. The lender will add in the mortgage payment they come up with based on your rate quotes and determine if it fits within your debt ratio.
Long-Term Strategies to Overcome a High DTI
Each loan program has specific debt ratios you must meet. They are as follows:
- FHA – 31/43
- Conventional – 28/36
- VA – 43% (they don’t have a housing ratio requirement)
- USDA – 29/41
If you are above these ratios, you’ll have some work to do before you apply for any of these loans. The easiest ways to reduce your DTI is to reduce your debts. Yes, you have to pay those debts down, or better yet, off completely. Of course, this is a change that requires careful planning and time. You cannot get out of debt in a matter of days – it could take months or even years, depending on how much debt you have. The more debt you pay off, though, the lower your DTI and the better your chances of approval.
Another way you can overcome a high DTI is to increase your income. This obviously isn’t as easy as possibly paying off your debts. If you get creative, though, you may be able to find ways to make side income or take on a part-time job. In order to use this money as qualifying income, though, you will need to make it for at least 12 months and in some cases 24 months before a lender will use it for qualifying purposes. If nothing else, you can use the extra money to pay down your debts and lower your ratios that way.
Other Ways to Lower Your Debt Ratio
If you can’t pay your debts down or make more income, you have a few other ways to help yourself get approved with a higher debt ratio.
You may have to lower your purchase price. This isn’t ideal, especially if you already have a home chosen, but a lower purchase price lowers your front-end and total debt ratio. It could be the answer you need to help you get qualified.
If your debt ratio is borderline, it may be just a few dollars that can make all the difference. Sometimes you can work this out by negotiating a lower interest rate on your mortgage loan or putting a slightly higher down payment on the home so that it lowers the loan amount.
One last method is to provide the lender with compensating factors. As the name suggests, these factors ‘make up’ for the higher DTI. They could be any of the following:
- High credit score
- Liquid assets on hand after making your down payment and paying closing costs
- Long employment with the same employer
- Steadily increasing income over the last few years
These are just a few of the factors lenders consider compensating factors. They help your credit application look less risky, giving lenders the reassurance they need to lend you the money for your home purchase.
It is possible to get approved for a mortgage with a high debt-to-income ratio; you just have to be creative. The key is in planning ahead. Don’t try to fix things overnight. If you know you want to buy a home in the next 12 months, start working on your credit score and debt ratio now so that when it’s time to apply for the loan, you are in a good financial position to get approved.