Your debt-to-income ratio represents the ratio of how much you spend on monthly debt payments including your total monthly housing expense and debt expenses to your monthly income. In short, the debt-to-income ratio for a mortgage determines how much of your gross income you can spend on your monthly mortgage payment which in turn determines what size loan you can afford. Lenders are required to verify that you can afford your mortgage payment and other housing-related expenses plus all of your other loan obligations so they limit how much of your income you can spend on total debt payments. That limit is your debt-to-income ratio.
Lenders typically apply a maximum debt-to-income ratio of 43% to 50% depending on the lender, loan program and other borrower qualification factors such as your credit score, down payment and reserves. The higher the debt-to-income ratio used by the lender, the higher the mortgage amount you can afford but the greater the risk because your debt expense increases so your financial cushion is lower. To qualify for a higher debt-to-income ratio (above 45%) you usually are required to make a higher down payment (~20%), meet a minimum credit score requirement (700) and have significant financial reserves (three to twelve months of monthly housing expense.
Your debt-to-income ratio is based on your gross income, so how much money you earn before any deductions for taxes, social security, medicare and retirement account contributions. The debt component of the ratio includes total monthly housing expense which is comprised of your mortgage payment, property tax, homeowners insurance and other potentially applicable housing-related expenses such as private mortgage insurance (PMI), FHA mortgage insurance premium (MIP) and homeowners association (HOA) dues. The debt figure also includes your monthly payments for credit card, personal, auto and student loans as well as alimony, spousal or child support payments, if applicable.
We should highlight that the debt component for your debt-to-income ratio is based on your monthly debt payments, and not your total debt balance. For example, if you make a $150 monthly payment on a $20,000 student loan, $150 is included in the debt figure used to calculate your debt-to-income ratio and not the $20,000 loan balance.
Please note that some lenders include an estimated figure for monthly payments on revolving debt accounts such as credit cards, even if your account balance is zero. For example, if you pay off your entire credit card balance every month, your account balance is zero which means that you will incur no ongoing monthly payments for the credit card, so technically your monthly debt payment figure for the credit card for the purpose of calculating your debt-to-income ratio should be $0. Some lenders, however, use an estimated monthly debt payment figure for the credit card even if the account balance is zero, especially if you incur charges and then pay-off your credit card bill every month. Be sure to ask your lender how they treat credit card and other debt with a zero balance that you pay-off every month.
Additionally, the monthly payments on amortizing loans such as car and student loans with less than six months remaining on the loan term are typically not included in the debt-to-income ratio for a mortgage. This is because you are close to paying off the loan completely and your monthly payments will terminate soon after your mortgage closes. Borrowers should consult their lender to determine how amortizing debt with a near-term pay-off date is treated when calculating your debt-to-income ratio.
The size of mortgage you qualify for is directly impacted by your debt-to-income ratio. The higher the percentage of your monthly gross income that you can afford to spend on your mortgage payment and total monthly housing expense, the larger the mortgage you can qualify for. Additionally, the lower your non-housing monthly debt expense such as for credit cards and other loans, the larger the mortgage you can afford because spending less on monthly debt expenses means you can spend more on your mortgage payment.
In addition to your debt-to-income ratio, what size mortgage you can afford depends on your mortgage rate, mortgage program and the length of your loan. The lower your mortgage rate, the larger the mortgage you can afford because your interest expense is lower. The mortgage program you select also impacts what size mortgage you can afford. An adjustable rate mortgage (ARM) or interest only mortgage typically enable you to afford a larger loan amount than a fixed rate mortgage because your initial interest rate and monthly mortgage payment are lower. It is important to highlight that your mortgage rate and monthly payment can change and potentially increase with an ARM or interest only mortgage so you need to make sure that you can afford the mortgage and payment over the duration of the loan. The length of your loan, or mortgage term, also determines what size mortgage you can afford. Longer term loans, such as a 30 year mortgage, enable borrowers to afford a larger mortgage because the monthly payment is lower than for a loan with a shorter term, such as 15 year mortgage.
Lenders consider multiple factors in addition to your debt-to-income ratio in evaluating a borrower's ability to qualify for a loan including credit score, employment history, down payment and loan program. Lenders also analyze your financial profile to make sure that you have the ability to repay the mortgage you are applying for using the government's Qualified Mortgage (QM) Guidelines. The guidelines are designed to ensure that borrowers obtain mortgages that they can afford and pay back over time. The Qualified Mortgage guidelines cover items such as a borrower's debt-to-income ratio, maximum mortgage term (30 years) and key loan features (balloon payments and negative amortization when your mortgage balance increases over time are prohibited).
In the example below we look at a borrower that makes $6,250 in monthly gross income and has $400 in other non-housing monthly debt expenses. We apply a 50% debt-to-income ratio to determine what size loan the borrower can afford. The example uses a relatively high debt-to-income ratio and it is important to highlight that lenders have discretion over what ratio they apply and certain loan programs use higher or lower ratios. The example also assumes a 3.750% mortgage rate and 30 year fixed rate mortgage. A lower debt-to-income ratio, higher interest rate or shorter mortgage length reduces what size loan the borrower in this example can afford.
Borrowers should work with their lender upfront to understand the debt-to-income ratio the lender uses as well as the inputs that go into calculating the ratio, especially as it relates to your monthly debt payments. We recommend that you contact multiple lenders in the table below to understand their loan terms and qualification requirements. Shopping multiple lenders and comparing loan programs enables you to find the mortgage that best meets your needs.
As we referenced above, the same debt-to-income ratio does not apply to all applicants or mortgage programs. For example, applicants with excellent credit scores, higher incomes and assets may benefit from a higher debt-to-income ratio. Additionally, if you make a larger down payment a lender may be more willing to apply a higher ratio. Alternatively, lenders may use a lower debt-to-income ratio for credit-challenged borrowers or applicants with limited incomes and assets.
Debt-to-income ratios also vary by mortgage program as different programs use different guidelines to determine what size loan you can afford. The table below outlines the debt-to-income ratio used for several conventional and government-backed programs. The higher the ratio used by the program, the higher the mortgage amount you can qualify for.
For borrowers with student loans, lenders use the actual monthly loan payment you are currently making to calculate your debt-to-income ratio. That may seem simple enough but there has been significant confusion on this topic, especially for borrowers on income-driven student loan repayment plans who make lower monthly payments than initially required by their loan terms. Because income-driven student loan payments are based on a borrower's discretionary income, they are typically much lower than the standard monthly payment originally required by the loan and some borrowers are not required to may any payment at all.
According to lender guidelines, as long as the borrower provides documentation to verify the lower monthly payment and as long as the lower payment is the result of an income-driven repayment plan, then the lender can use the lower payment figure to calculate the borrower's debt-to-income ratio. Using the lower, actual student loan payment figure improves your debt-to-income ratio and enables you to qualify for a higher mortgage amount.
Deferred student loans are treated differently than loans on an income-driven repayment plan. Payments on deferred students loans are typically still included when you apply for a mortgage, even though you may not currently be making a payment. The monthly debt expense for deferred student loans is calculated as either 0.5% or 1.0% of the outstanding loan balance or the full payment amount according to your loan documents, depending on the lender and loan program. So although you may not be required to make a monthly payment, lenders include some amount of student loan expense in your debt-to-income ratio, which reduces the mortgage amount you qualify for. This is because although you may not be making a loan payment today you may be required to in the future and lenders want to make sure you can afford both your mortgage and student loans.
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Conventional Loan Debt-to-Income Ratio: https://www.fanniemae.com/content/guide/selling/b3/6/02.html
FHA Mortgage Debt-to-Income Ratio: https://www.hud.gov/sites/documents/14-02ML.PDF
VA Home Loan Debt-to-Income Ratio: https://www.benefits.va.gov/WARMS/docs/admin26/pamphlet/pam26_7/ch04.pdf
USDA Home Loan Debt-to-Income Ratio: https://www.rd.usda.gov/files/3555-1chapter11.pdf