So many people are buying houses this year. Becoming a homeowner or even selling your current home and buying a new one can be both an exciting and overwhelming process. If you’re looking to get another mortgage. One hidden factor you need to consider is your debt-to-income ratio.
Your debt-to-income ratio or DTI is used to evaluate your creditworthiness as a borrower. It consists of the total amount of all your minimum monthly debt payments compared to your monthly income. What this looks like is debt payments divided by monthly income.
So if you’re paying an average of $1,000 in debt payments (between your credit cards, car loan, and student loans) and earn $3,200 per year, your DTI is around 31%. While lenders are generally looking for a DTI of around 36%, some might accept a ratio as high as 43% to approve you for a loan. Even if you can get approved with a higher DTI ratio, there are several reasons why you may want to lower it.
Why Your Debt-to-Income Ratio Should Not Be Too High
When you take on a mortgage, it likely represents one of the largest debts that you can have. Lenders want to know that you can handle making your mortgage payments along with your other debt payments. Plus, you still need money left over for other bills, food, and entertainment.
In the example above, the DTI is technically acceptable for a lender, but it still might not be low enough for the borrower. With $1,000 per month already going toward various debts, the potential borrower is already using 30% of their income for debt. Add on a mortgage at $1,300 per month, and that’s a total of $2,300 or 71% of their monthly income going toward those bills. This leaves only $900 leftover for food, household items, gas for transportation, and other monthly expenditures.
As you can see, your DTI is not just important for the lender, but it’s a key element for you to pay attention to also. No one wants to become a homeowner and have their housing expenses eat up their entire income.
You likely want to enjoy your home, but also dine out from time to time, spend time with friends, or go on a vacation and be able to afford it. Only you can determine your ideal debt-to-income ratio when you’re looking to buy a house. Your best bet is always to lower your target even if you think you’d be okay with a certain percentage. Here are some tips to help.
Start by Tackling Your Credit Cards
Credit card debt is not something you want to carry month-to-month in general But for homeowners, it can be more of a hassle when you’re juggling card payments with a mortgage payment. Yes, credit card minimum payment amounts are low, but it also depends on your total balance. If you have $3,000 to $5,000 of credit card debt, for example, your minimum payment could be higher than the usual $25 to $35 amount.
Also, lenders may be considering the total amount of your debt. If it looks like you can’t realistically pay off your debt totals and pay your monthly mortgage payment, you may not get approved.
Once you do get a mortgage, you’ll have extra expenses like maintenance, repairs, and even home projects. You simply may not be able to deal with credit card debt so it’s best to tackle as much of it as you can beforehand.
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Prioritize Your Debts
When it comes to your other debts, prioritize them to see which one you may want to make extra payments on. In terms of lowering your DTI ratio, you may want to tackle the debt with the largest monthly payment. This could be your car loan, student loan, or a personal loan. Tackling the debt with the biggest payment is just one way to prioritize your debts.
However, the choice is ultimately up to you. You may want to work on the debt with the smallest balance or the highest interest rate. Realize that by simply paying off one or two debts before you get a mortgage, you’ll be lowering your DTI ratio either way.
Avoid Making Large Purchases
Avoid making any large purchases that could cause you to get financing when you’re about to apply for a mortgage. If you’re thinking about getting a new car, see if you can postpone the decision until you buy your home. Or, if you’re planning to get furniture or things from your home, use the cash you have or wait if you’re thinking about financing.
Opening a new account is one of the worst things you can do when trying to buy a home. It increases your debt-to-income ratio and throws things off. At the very minimum, it can cause you to fill out more paperwork and prolong the homebuying process. In the worst-case scenario, it can prevent you from qualifying for a mortgage altogether.
Include Income From a Long-Term Side Hustle
Some people don’t realize this but if you do contract work, freelance, or have a side hustle that you pay taxes on, you may be able to include this income in your loan application. When my husband and I bought our first home, I included the income from my freelancing business since I had at least two years of tax returns reporting that income. Then we realized my husband had been driving for Uber for two years. So we included those statements too.
This side hustle income helped add to our monthly income total making us appear as stronger borrowers. With more income from diversified sources and less debt overall, we didn’t have any issues with meeting our lender’s DTI requirements.
Summary: Your Debt-to-Income Ratio Matters..A LOT
Your debt-to-income ratio is one of the most important and often most overlooked aspects that heavily factor into your mortgage approval. If you want your dream of having a home to come true you’ll need to have your debt-to-income ratio in order.