Lenders use debt-to-income ratio, or DTI, to help determine the monthly mortgage payment you can afford. This ratio, calculated as a percentage, is found by dividing your monthly debts by your gross monthly income (your total pay before taxes).
There are two types of debt-to-income ratios lenders look at: front-end and back-end. Front-end DTI focuses on your proposed monthly mortgage payment, including taxes and insurance. This amount is divided by your gross monthly income to get your ratio.
The back-end DTI takes into account your current monthly debts in addition to your proposed monthly mortgage. Your total monthly debt is then divided by your gross monthly income. While both ratios are considered by your lender, the back-end DTI gives a more comprehensive view of your financial situation, and therefore holds more weight in the process.
In addition to your proposed monthly mortgage payment, the back-end debt-to-income ratio factors in student loans, credit card payments, auto loans, personal loans, alimony and child support, and mortgage payments on other properties.
The back-end DTI ratio does not factor in bills such as cell phone bill, cable and internet, health insurance premiums, car insurance premiums, utility bills, landscaping, cleaning services, etc. Because back-end ratios don’t take into account all of your monthly expenses, they include a buffer to take into account these additional expenses. This also means, however, that you can sometimes be approved for more than you can comfortably afford, depending on your lifestyle. Your mortgage broker will be able to discuss this further with you so that you can set a maximum budget for a mortgage payment that works with your financial situation.
Most loans, including Conventional and FHA loans, require your back-end debt-to-income ratio to be at or below 43%. The lower your DTI, the less risk you are to the bank or lender. Of course, this percentage can vary depending on the lender, with some lenders will approve loans with a DTI up to 50%.
In order to lower your debt-to-income ratio, you must reduce your debt. Work to pay off credit cards, personal and student loans. At the same time, avoid taking on any more debt as you prepare to become a homeowner.
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