When mortgage lenders approve borrowers for a loan who have completed applications on STEM Lending’s site, that decision is based on a standard set of guidelines that are generally determined by the type of loan program. Today, we are going to focus on one of the main components of a mortgage approval: Debt-to-Income (DTI) Ratios.
Many potential home buyers have only a rough idea before applying — even for a pre-approval letter — about their own DTIs, how lenders view them, and what sort of obstacles they’re likely to encounter.
How Do I Calculate DTI?
Your debt-to-income ratio is all your monthly debt payments divided by your gross monthly income. This number (reflected as a %) is one way lenders measure your ability to manage the payments you make every month to repay the money you have borrowed.
The lower the DTI ratio a borrower has (more income in relation to monthly credit payments), the more confident the lender is about getting paid on time in the future based on the loan terms.
Your gross monthly income is generally the amount of money you have earned before your taxes and other deductions are taken out.
For example, if you pay $2000 a month for your mortgage and another $200 a month for an auto loan and $500 a month for the rest of your debts, your monthly debt payments are $2700. ($2000 + $200 + $500 = $2,700.) If your gross monthly income is $7000, then your debt-to-income ratio is 38.57 percent. ($2700 is 38.57% of $7000.)
What is Front-End vs. Back-End DTI?
Debt ratios for home loans have two components.
The Front-end DTI ratio measures your gross income from all sources before taxes against your proposed monthly housing expenses, including the principal, interest, taxes and insurance that you’d be paying if the lender approved the mortgage you’re seeking.
The Back-end DTI ratio measures your income against all your recurring monthly debts. These include housing expenses, credit cards, student loans, personal loan payments and others. Under federal “qualified mortgage” standards, your back-end ratio maximum was capped at 43%, although with recent announcements from Government Sponsored Enterprises (GSEs) Fannie Mae and Freddie Mac, there is wiggle room case by case
Why is the 43% Debt-To-Income Ratio so Important?
For loans to be eligible for sale to Fannie Mae or Freddie Mac, lenders have to follow the 43% guideline set by the GSEs.
The federal “qualified mortgage” rule sets the safe maximum at 43%, although Fannie Mae, Freddie Mac and the Federal Housing Administration (FHA) all have exemptions allowing them to buy or insure loans with higher ratios.
FHA traditionally allowed DTIs over 50% for some borrowers, however those borrowers have to pay private mortgage insurance (PMI) for the life of the loan.
Freddie Mac also uses private mortgage insurance and will accept loan applications with DTIs above 45%.
Fannie Mae will be raising its DTI ceiling from the current 45% to 50% as of July 29, 2017.
Fannie Mae also uses private mortgage insurance on its low down payment loans, but the premiums are automatically canceled when the principal balance drops to 78% of the original property value.
As an prospective borrower, your application will still have to go through Fannie’s automated underwriting system (Desktop Underwriter), which examines your entire application, including the down payment, your income, credit scores, loan-to-value ratio and a slew of other indexes.
Studies by the Federal Reserve and FICO, the credit scoring company, have documented that high DTIs doom more mortgage applications — and are viewed more critically by lenders — than any other factor. And for good reason: If you are loaded down with monthly debts, you’re at a higher statistical risk of falling behind on your mortgage payments.
In general, we think your front-end and back-end DTI ratios should be 28% and 36% respectively, or lower.
- FHA limits are currently 31/43, though these can be higher with justification from the lender.
- VA limits (for veterans) are only calculated with one DTI of 41.
- Conforming loans have to conform with the DTI limits we mention above for your mortgage loan to be eligible for sale to Fannie Mae and Freddie Mac
- However, a non-conforming (Jumbo) loan does not conform to purchasing guidelines set by Fannie Mae and Freddie Mac
To learn more about DTIs, head over to Fannie Mae’s “Know your options” site (www.knowyouroptions.com).
As always, follow our STEM Lending Blog for more relevant content for you as your home buying process moves forward.