Thomas Jefferson once said, “Never spend your money before you have it.” Debt encapsulates the opposite of this in many ways. Credit is receiving the money you don’t have, which automatically means you will have to pay it back. It causes a false sense of security that is short-lived, and then reality comes rudely knocking in. A mortgage is a debt, and taking it on top of another debt is risky enough.
Debt-To-Income (DTI) Ratio
Mortgage lenders have to vet borrowers seriously before approving any mortgage plan. This process involves professional underwriting and evaluation. As such, an individual’s credit score matters. A higher credit score means the borrower is more creditworthy and can be trusted with credit.
To quantify this accurately, lenders use a mathematical model called debt-to-income ratio (DTI). Here is how to calculate DTI:
Monthly Debt Obligations / Gross Monthly Income
For instance, assuming X’s gross salary is $5000, and the monthly expenses add up to $1200, the debt-to-income ratio is;
1200/5000 × 100% = 24%
Lenders typically consider a DTI of more than 36% as excellent, with 43% being the upper limit. Lower DTIs mean that the borrower is closer to living a debt-free life. Lenders prefer giving mortgages to individuals with low DTIs. From the above example, a DTI of 24% is suitable to receive a mortgage.
What DTI reveals is how an individual’s spending habits. If the DTI is low, it means that the individual is using their income wisely and is not taking out more debts or is at least financing the existing debts. It is not about how much you earn but how you spend it.
An individual with a low income but excellent spending habits may have a low DTI and this be eligible for more credit, while an individual with a high income but poor spending habits may have a very high DTI. Individuals can use this metric to test how well they use their income.
Front-end ratio vs back-end ratio
- Front-end ratio – yearly gross income that is directed towards paying your mortgage. It should not exceed 28%.
- Back-end ratio – annual gross income that is directed towards paying your debts. It should not exceed 43%.
Lowering Your DTI
There are several ways to improve your debt-to-income ratio. One of these ways is to reduce your monthly habits; in other words, decrease your recurring debts.
The other option would be to increase your gross monthly income. This can be achieved in the following ways:
- Work overtime
- Work more than one job
- Request for a promotion
- Pursue higher education than you currently have to increase your market value
Is DTI an adequate measure of mortgage affordability?
As a rule of thumb, the mortgage amount that you can afford is twice to two-and-a-half times your gross income. Our example above shows X’s mortgage lies between $10,000 and $12,500.
Lenders consider numerous factors to gauge a borrower’s mortgage affordability, such as gross income, front-end ratio, back-end ratio, and credit score. More overlooked but equally important factors include lifestyle and personality. So while DTI measures mortgage affordability, it is not a perfect metric.
Some lenders may allow mortgage requests to individuals with more than 43% DTI. However, these lenders may subject the borrowers to more intensive screening, such as checking one’s credit score.
Further, using the DTI metric, one completely ignores expenses such as food, insurance and utilities. It is best to use online mortgage calculators to determine the house you can purchase and what monthly installment you should pay, considering your income.
How much debt is too much for a mortgage?
This leads to the elephant in the room: when do we say the debt is too much for a mortgage? Answering that question cannot be summarily placed in a precise answer. However, there is a point where obtaining a mortgage can be difficult, if not impossible.
A DTI of above 43% speaks much about one’s debt culture. Any debt above 50% of one’s income is risky. It means that the individual will have to pay back more than half their salary for debts, which is not a good picture, especially if one is considering getting another loan.
Can you still get a mortgage even with too much debt?
Admittedly, yes. Although it will be hard to convince lenders of your creditworthiness (even when it is too low), obtaining a mortgage with a less than honorable debt culture is possible.
One caveat is to consider refinancing and take advantage of periods where low-interest options are offered. Refinancing involves the revision of a borrower’s credit amount and repayment status. Refinancing a mortgage means completing the payment of the original mortgage and then replacing it with another one. It can cost about 3% to 6% of the principal amount.
Another option is to get a co-signer. They should have a better credit history and credit utilization than the borrower. A co-signer helps pay back any loans the borrower may fail to pay or the entire mortgage amount.
The final option is to devise a clear plan of action to convince the mortgage lender to consider you for mortgage options despite your poor credit history. Use effective communication skills to get the lender to understand your credit position and show how you are working towards making it better.
In closing, everyone needs a good house to live in. Mortgages became a saving grace to most individuals, mainly because of low-interest rates. Debt can hamper such dreams, as lenders consider high debt-to-income ratios very risky to work with. They may be unsure if the borrower will pay back in time and in full.
When all is said and done, it is judicious to devote a few months to decreasing your DTI before taking a mortgage loan. A bird in hand is better than ten in the bush. The money you have is what you have, not what you’re hoping for.
