Lowering Your Debt-to-Income Ratio
Debt-to-income ratio or DTI is one of the key components of your financial profile lenders review when evaluating whether or not you are a good candidate for mortgage financing. DTI thresholds vary depending on the lender and the type of mortgage loan. Generally, the lower your DTI the better, so lowering your DTI by paying down long-term debts and limiting credit card use is a good idea before you apply for mortgage financing.
Simply stated, your debt-to-income ratio is your total monthly debt divided by your gross (pretax) income. Monthly debt includes long-term, nonrevolving debt like student loans, car loans, or installment loans that have a fixed payment each month, and revolving debt like credit cards. For revolving debt, lenders usually look at the minimum monthly payment not the total balance. Even so, it’s still a good idea to pay down as much of the balance as you can each month, so the debt does not add up. The DTI will also factor in your monthly mortgage payment, if you are a current homeowner.
For example, if your monthly gross (pretax) income is $5,000 and you pay $500 toward your student loan debt and minimum credit card payment plus $1,200 for a monthly mortgage payment your DTI equals 34%. Looking good! Most lenders prefer a debt-to-income ratio of 36% or less, but maximum DTI will vary depending on the type of loan programs. Government loans like the FHA Loan, the VA Loan, or the USDA Loan have more lenient DTI requirements, while conventional loans will have more conservative requirements. The maximum DTI accepted will also depend on your credit score and other variables. If you have a lower credit score, you may also need a lower DTI to qualify for mortgage financing. If you have a good or excellent credit score, a higher DTI may be accepted.
Lowering your debt-to-income ratio is a good idea before you apply for mortgage financing. However, any major financial changes, including paying down debt, once the application is in process could be potential red flags and slow down the transaction. A few of the money moves lenders want you to avoid during the mortgage application process are:
- Making any big purchases (that new car can WAIT until you have a new garage)
- Consolidating credit cards or paying off any collections
- Opening new lines of credit
- Changing jobs
- Cosigning for another borrower on a different loan
- Opening and closing accounts
Most lenders recommend starting credit repair six months to one year before you apply for mortgage financing. If you know you are going to be looking for a home in the next year, consider lowering your debt-to-income ratio before you start the financing process. If you’re not sure how your DTI will impact your chances of getting approved, consider starting with a prequalification. Every financial situation is different, so getting prequalified with a mortgage lender is a great way to see where you stand, review your mortgage options, and set achievable goals.