If you’ve been focusing on improving your credit score, but your financials haven’t received much attention, you could be setting yourself up for mortgage failure. Whether you’re trying to refinance your existing mortgage or get a loan for a new home, your debt-to-income matters.
Most buyers think that a good credit score will get them a great mortgage. Unfortunately, this is far from the truth. Although your credit score is one of the factors considered when purchasing a new home, your debt-to-income may actually be more important when determining the amount of money you qualify to receive.
Why Debt-to-Income Matters in Mortgages
Lenders look at your debt-to-income to determine how much of a loan you can actually afford. If you make $100,000 / year but have 50% of your income going to expenses (housing-related expenses, debt, student loans, car payments, ect.), the lender may determine that you can’t afford the home loan. As you plan to purchase or refinance your home, it’s important to get your debt-to-income ratio down to under 36%.
How to Figure Your Debt-to-Income (DTI) Ratio
There are two types of debt-to-income ratios that you need to consider. Lenders will look a what is called your front-end ratio and your back-end ratio.
What is the front-end ratio? The front-end ratio is the percentage of your income that will go toward your housing expenses including the mortgage payment, taxes, insurance, and other dues. Most lenders want your front-end ratio to be no more than 28% of your income.
What is the back-end ratio? The back-end ratio is the percentage of your income that is needed to cover all of your monthly expenses. This will include your monthly housing expenses plus any credit card debt, car loans, student loans, or other monthly expenses. Most lenders want your back-end ratio to be lower than 36%.
As you’re planning to buy a home, it’s a good idea to develop realistic expectations about how much of a mortgage you can afford. To calculate how much of a mortgage payment you can afford, multiplying your monthly income by 36%. For example, if your monthly income is $5,000 / month, your monthly expenses should not exceed $1,800 / month to maintain a DTI ratio of 36%. Depending on your debt obligations, this will give you a ballpark for how much you can spend each month on your mortgage payment.
How to Improve My Debt-to-Income Ratio
The best way to improve your debt-to-income ratio is to pay off as much of your debt as possible. There are several strategies you can use to make this happen faster.
- Increase the amount you pay toward debt every month.
- Pay off high interest rate credit cards first. When you have high interest rate credit cards, it’s a good idea to put any extra money you’re paying toward debt on the high interest cards first. This will pay down these high rate cards faster because you’ll be spending less on interest.
- Avoid new debt. Don’t open new credit cards or charge more on your cards.
- Don’t make large purchases that require your credit card. Instead, save money monthly until you have enough to make the purchase with cash.
If you’re serious about improving your debt-to-income ratio so you can receive a great home loan, consider using a tool like Mint.com to plan a budget and start managing your finances.