What is DTI and How Does It Affect Me?
The number one question we get from borrowers here at MJG Capital is "how do I know what I can afford?" It's a good question and the answer is far simpler than you may think.
"What Is DTI and How Does It Affect Me?"
Determining a maximum purchase price is contingent on calculating a borrower's DTI, or debt-to-income ratio. Calculating a DTI takes into consideration a borrower's income, proposed payment, and minimum monthly payments for items that appear on a borrower's credit report. A homebuyer's DTI needs to be below federal lending guideline limits in order for a loan to be approved.
To begin, we'll start with gross earnings. Gross earnings is the amount of money any mortgage applicants and their co-borrowers earn before any taxes or deductions are removed from their pay check. If an applicant makes $27 dollars per hour and works full-time, their gross earnings would be $1,080 per week ($27x40 hours). $1,080 per week times 52 weeks in a year would come out to an annual gross income of $56,160. Divide this number by 12 and you'll come up with a gross monthly income. In this case, the gross monthly income for this applicant would be $4,680.
Let's assume this borrower wishes to buy a condo that will have an all-in payment of $1,450. In order to calculate the front-end DTI, we divide the proposed mortgage payment of $1,450 by the gross monthly income ($4,680). $1,450/$4,680 equals 30.98%. In plain English, we're are able to say "This borrower's front end DTI of 30.9 indicates that s/he will spend almost 31 percent of their money on housing alone if they took on this mortgage." A front-end DTI of 31 is healthy and common. Generally speaking, there is no limit to what a person's front-end DTI may be.
::: Take a deep breath, we're almost there! :::
We have one more thing to figure out once we've calculated the front-end DTI. You guessed it: The back-end DTI! The back-end DTI is a measure of how much of a borrower's gross monthly income is spent on their housing payment and on the minimum payments for the bills that show up on their credit report. Continuing with the example given above, let's assume that this applicant has a $199 car lease payment, a $175 minimum payment on a credit card and a $65 payment on a student loan. The total of these minimum payments ($439) plus the proposed payment of $1,450 comes out to a total minimum monthly payment of $1,889. $1,889/$4,680 equals a back-end DTI of 40.36%.
So, what's the limit?
The maximum back-end DTI ratio for a conventional loan is 50%. For an FHA loan, it's 57%. In either case, this loan would be approvable based on the debt-to-income ratio assuming the applicant has good credit.
If your DTI ratios are too high, there's a few things you can do:
1) Reduce your debt load by paying some debts down or off
2) Purchase a home with a lower payment that is more aligned with your ability to pay
3) Add a co-borrower to your loan. Their extra income will lower your debt-to-income ratios assuming they don't have as much or more debt as you do.
4) Look for more income. Often times overtime, alimony, child support, bonuses, etc. are overlooked by mortgage professionals. Taking a second glance at an applicant's pay stubs and tax returns might increase calculated gross monthly income and decrease DTI.